As much as we like to think that we’re objective human beings that make decisions based on appropriate information, time and again behavioural science tells us otherwise. Our cognitive biases result in us making decisions based on mental shortcuts. In this post, we’re discussing our stereotypes. Conjunction fallacy, base-rate fallacy and representativeness heuristic all deal with how we make associations that we shouldn’t.

1. Audience participation
2. Conjunction fallacy
3. Representativeness heuristic
4. Let’s play another game
5. Past performance doesn’t guarantee future returns
6. The bad and the ugly
7. Don’t be lazy

Let’s start with some audience participation… Let’s say I conducted the following health survey on a sample of adult men of all ages and occupations in your city.

Now, compare your two answers.

For most people, the percentage estimated is higher for question a), than for question b).

If that’s how you answered, consider your estimates carefully, because they’re wrong!

There will always be more people who’ve had a heart attack, than people who’ve had a heart attack and are over the age of 60 years. Think through it again… question a) is merely a subset of question b). But, we are influenced by the narrative in question a) rather than the logic of the analysis.

This is known as conjunction fallacy. It explains our faulty reasoning where we think a conjunction of two ideas is more probable than just the one idea. This is also why detailed explanations are often more believable than general ones.

Remember that every day our minds need to deploy knowledge to carry out an array of cognitive tasks. These range from perceptive to reasoning to decision making and motor skills. This is some heavy lifting. To add weight to this, often the facts we deal with are uncertain. And often we are surprised by information that requires us to entirely reassess our status quo. Because of our limited cognitive resources, we need to take mental shortcuts to reduce the cognitive load.

Conjunctions and details are one thing. But we also make associations between things that are often tenuous. Why do we do that? Well, it helps us with making decisions. But it also means we’re making judgments based on stereotypes. Yes, I said it. We stereotype. And representativeness heuristic is the nice name we’ve given it (it would be too brazen to call it stereotyping bias).

Whenever we encounter something new, be that a person, investment, business – we classify it based on how closely it resembles a stereotype.

According to the fathers of behavioural finance, psychologists Amos Tversky and Daniel Kahneman (1972), the representativeness heuristic is defined as:

Did you do it again? Are you stereotyping?

You can also pass some blame to the availability heuristic here. We’re not good at searching all of our memory for the best answer, we rather recall something that more or less fits that which we can easily bring to mind. It’s why most people invest in well-known and popular shares, as an example.

Representativeness can help us in grouping together things that have shared qualities. And it’s often a self-fulfilling prophecy in that “birds of a feather, flock together”, but it’s a bias that limits opportunities. It superficially explains things but is flawed when predicting human behaviour. This is problematic if you’re trying to solve real-life problems, particularly those that involve money (hello behavioural psychology).

With representativeness heuristic, we see similarity between objects or circumstances and that impairs our ability to assess the probability of an event. So, we make the mistake of believing two similar things or events are more correlated than they actually are.

We use prior experience, rather than fundamentals, to set unique reference points when making investment decisions.

For the financial planners reading this…  your clients are seeing the fall in the market and they are worried that the movement is going to continue. It doesn’t matter how many times you show a graph of upward growth with volatility, when we’re sitting in the dip, that’s all we can see.

Remember, after the Great Depression, adjusted for inflation – it took two decades for the market to return to its previous level. Two decades! It’s not entirely unfounded when we look at the current short-term crash and fear it getting worse!

So there’s this sort of hangover of fear at the moment. Which creates panic selling and knee-jerk reactions because there’s so much anxiety.

You can’t really avoid this one. But you can lessen its impact by endeavouring to do proper research before you make superficial comparisons. Any small downturn in the market and we hear people comparing it to the Great Depression (I cannot tell you the number of people who have mentioned the Great Depression to me during the chaos currently being experienced in the financial markets). We’re making lazy comparisons. Just because something reminds you of something else doesn’t mean it’s similar.

Did you know that a strawberry is not really a berry but that a banana is? Case in point – do some research!

• Heuristics and biases in decision making – This was the first post in the series which shares some behavioural economics research. Specifically, the heurstics and biases that influence our relationship with money. It uses System 1 and System 2 thinking examples from Daniel Kahneman’s New York Times best selling book, Thinking Fast and Slow, to help us be more conscious of the workings of our brain. 

• Mirror, mirror, on the wall, stop telling me I’m wonderful – This post focuses on the impact of overconfidence bias in decision making. It introduces the illusion of knowledge bias and the illusion of control bias to illustrate the difference between confidence and carelessness. It also discusses the better than average effect, the self-serving bias and fundamental attribution error. You’ll learn how to confront some unpalatable truths and get out of any false sense of comfort (if you’re up for the challenge?).

• Why you can’t argue with a vegan – Ballsy title, we know. But if you read the post you’ll (hopefully) understand why. We’ll be discussing confirmation bias. It’s one of those psychological biases that you can see everywhere. We’ll also touch on cognitive dissonance theory. We all struggle with these biases. They’re both humorous and serious. But because of that, it’s useful to know how to avoid confirmation bias when you need to.

• Size does matter… when it comes to framing – This post uses framing effect examples to show how framing bias influences the way we interpret information and make decisions. We discuss glossing, the compromise effect, and how the size of the frame can influence the volatility of your investment portfolio.

• Loss aversion vs risk aversion – Once you understand framing, you’re ready for this post. It introduces an incredibly powerful bias known as loss aversion. It also touches on prospect theory, the disposition effect and impression management.

• Anchors pulling you down? – Anchoring bias is a straightforward behavioural bias that causes us to focus on a certain initial value and then make decisions with reference to it. This posts looks at some examples of this anchoring effect.

• The danger of the default – Default options nudge us to make better decisions. The option of opting out also respects freedom of choice. This post unpacks this notion of libertarian paternalism and the perils of status quo bias.

• Regret, it’s not a nice feeling – Regret influences the decisions we make and pushes us to conform to social norms. Examples of regret avoidance show us how this makes complete sense yet no sense at all.

• When the past influences the future – The Concorde effect is a famous example of sunk cost investment. Too often we invest time, money and energy into something we should’ve just abandoned. This post looks at some examples of how sunk cost fallacy affects our human decision processes.

• What’s mine is more valuable – In this post, you’ll learn why you place extra value on things you own. The endowment effect has implications for our investment portfolio, bonuses and consumer behaviour.

• How to improve self-control – Self-control is an essential life skill. It’s what separates humans from the rest of the animal kingdom. Learn how to improve self-control to achieve your long-term goals.

• Procrastination is the enemy of success – We know procrastination is the enemy of success. But while it looks like laziness, it’s often just mental exhaustion at play. Learn how to overcome procrastination.

• The problem with wanting it now – When you delay instant gratification, you will experience long-term satisfaction. It’s the hyperbolic vs exponential discounting debate. Don’t let present bias win!

• The power of first impressions – The order of information influences your decisions. First impressions matter! It’s all got to do with primacy and recency effects.

• We prefer wrong information to no information – Availability bias and survivorship bias influence our decision-making. We make decisions based on the information available to us.

• Learn to deal with uncertainty – Risk and uncertainty will always surround us. Gambler’s Fallacy, the hot-hand effect, the law of small numbers & ambiguity aversion are just some of the biases that arise because of it.

• Mental Accounting – Money is money! Or is it? Mental accounting says we place different values on different money which leads to irrational decision making.

• Money Illusion– Money illusion is a sneaky bias. It causes us to focus on the amount of money in our hands, rather than it’s purchasing power.

• Home bias – We invest close to home and in what we know. But this lack of diversification results in missed opportunities. Say hello to ‘home bias’.