Chapter 7

A little knowledge is dangerous (representativeness)

A researcher stopped people in the street and asked if they would participate in a short survey. There was only one question: First, let me tell you that Tony is tall, well groomed and frequently heard whistling classical music. My question: Is Tony more likely to be a public servant or a concert pianist?

This kind of question has been asked many times in research projects in a wide range of countries. Which occupation was most frequently chosen by people in the street: public servant or concert pianist?

We would be in the clear majority if we chose concert pianist as Tony’s most likely occupation. There is a good reason why so many people are likely to make this choice. Moreover most people quite unconsciously do this in many situations throughout their lives.

We were asked whether we thought Tony was a public servant or a concert pianist. There were no other choices we could make. Supposedly to help us make our choice, the researcher gave us three pieces of information:

• Tony was tall.

• Tony was well groomed.

• Tony was frequently heard whistling classical music.

Seemingly, this information was all we had to go on, so we latched on to the information given that Tony was whistling classical music. Nevertheless, a savvy gambler would have bet that Tony was more likely to be a public servant than a concert pianist. Why?

It is simple really: there are very few concert pianists in the country, or indeed in the world. However, every country has many thousands of public servants. Therefore, if we sensibly ignore the three pieces of irrelevant information provided and go with the probabilities, we would plump for public servant. We are far more likely to be right. Of course, in a specific case, we could be wrong. However, if we go through life making a great many similar choices based on the probabilities, we will tend to be correct most of the time.

Why do so many of us get it wrong? Again, it is simple really. We forget about probability and rest our choice on what seems to be a clue that we see to be representative of concert pianists: Tony is often heard whistling classical music. Because all concert pianists will play classical music and love what they are doing, they are likely to be whistling the music they play for a living. However, many public servants also like classical music and they are therefore also likely to be heard whistling it. Whistling classical music therefore really tells us nothing about the choice we were asked to make, especially when we were asked which occupation was most likely for Tony.

In computing science, there is a process called heuristics, in which a program tries to learn from its own experience. This is, in fact, mimicking the way people learn to deal with the world around them. We deal with most problems through the use of judgemental heuristics, which in non-technical jargon simply means rules of thumb or shortcuts, in order to simplify complex decisions. Most of the time, these shortcuts are very useful and effective. However, they can also lead us into error.

Sometimes these rules of thumb are applied consciously. An example would be the rule popularised by Benjamin Graham, which we might use quite deliberately: that a stock with a price–earnings ratio below 15 times represents acceptable value. However, many rules of thumb are unconscious. Whether conscious or unconscious, they are frequently the areas in which we are led into making errors of judgement.

One unconscious rule of thumb that leads us into trouble is called representativeness in academic jargon. If we need to make a judgement about something, representativeness is when we look for another situation that is similar in some respect to the present one and base our judgement on that characteristic alone. This will cause a poor judgement if the characteristic we have used was not what really determined the outcome in the situation that we are considering. The representativeness problem is far more common than we think in complex and uncertain situations such as investment decisions.

The research done on representativeness shows that we all tend to see similarities between situations where there is actually little or no similarity. We do this by using analogy. Confronted with a new situation, our minds retrieve a memory from our experience that resembles the new situation in some way. Now we have something familiar against which to judge the new situation. This is why alarm bells go off in the minds of many people who have been trained in logical thinking as soon as they hear any analogy used as a way to justify or prove something.

Representativeness leads us into making poor judgements in two general ways:

• when we give too great a weight to similarities between situations, ignoring the probability of the possible outcomes

• when we focus on the similarities to such an extent that we reduce or overlook the factors that really determine the outcome of the situations.

Representativeness bias occurs when we base a decision on what looks or sounds right, but ignores the base rate, which is the smarter answer.

For example, the futures markets fascinate Jason. He wants to become a full-time trader and has saved up some money to use as a stake. His friend Lachlan went to the same school and university, and achieved the same grades in the same subjects. Lachlan’s dad is very rich and gave his son some money to trade futures. While Jason was saving up his stake, Lachlan made several million dollars trading futures.

If we were to ask Jason what his chances are of succeeding at futures trading, he would look at Lachlan’s education and his success and probably judge that his chances were very good. Many people, given these facts, might agree with his assessment. Yet the base rate, or the general experience, for futures traders is that 90 per cent of them lose money trading. Moreover, experience suggests that success in futures trading has nothing to do with education or intelligence. If asked to assess Jason’s chances, the best prediction to make is that he has only one chance in ten of succeeding and the best answer to Jason’s question is that he will not succeed.

Another of the more pernicious of representativeness traps is the idea that although we recognise the base rate, we do not think it applies to us. This is known in behavioural finance as overconfidence, which we explored in chapters 2 and 3. Everywhere there are warnings that trading options is dangerous and that nine out of ten options expire worthless. Yet there are countless tyros who venture into options trading every year in the belief that they will make money because they are smart or because they have read about or invented a method that will make them rich. One of the saddest examples of this was the US hedge fund Long Term Capital Management, backed with the skills and knowledge of a team of academics, including Nobel laureates in the field, who came unstuck spectacularly, finding that the base rate also applied to them.

Every bull market brings with it numerous examples of the representativeness trap in action. Indeed, representativeness is one of the driving forces behind the development of speculative bubbles. One of the ways it operates is in the area of stock selection. Every bull market is led by a small number of stocks that are very successful. Their prices go up in a few years from low prices to prices that are five, ten, twenty or even one hundred or more times the starting price.

An outstanding and well-known example of the sort of stock that led the 2003–07 bull market is Fortescue Metals Group. Adjusting for the subsequent ten for one split, someone buying on the first day it listed in 2003 at 2.65¢ and holding until the peak in 2005 of 55.5¢ would have seen their stake increase nearly twenty-one times. Someone investing $10 000 on the first day had a holding worth $209 434 only 19 months later.

Now, what inexperienced investors do is to think they are too late to make money out of buying Fortescue Metals Group. After all, no tree grows to the sky does it? So they look around for a stock that is like Fortescue. They find another mining company that is just starting to develop a mine. The prospectus may even imply that the new company will be modelled on Fortescue.

What usually happens then is that these investors lose all or most of the money they invested in the new venture. I can be reasonably certain of this simply because the base rate for new start-ups is that most of them fail. Fortescue Metals Group was one of the exceptions. Its success was probably driven by factors other than that it was simply a mining company.

While our tyro was losing on the new mining company, Fortescue powered on, increasing the 2003 stake to a peak of $13.15 in mid 2008, when our intrepid investor’s holding would have been worth just less than $5 million. Clearly, Fortescue Metals Group was something special. Focusing on the simple factor that it was a mining company would have led us to ignore the critical factors that were driving its success.

Test yourself — have you fallen for these kinds of traps?

• I read that WD Gann made $50 million from trading. I can become a successful trader by following his methods.

• The present market has started down just like the great crash of 1929, which was followed by a long depression. I will sell all my stocks now before it is too late and buy bonds.

• Bricks and Tiles Limited is up 200 per cent. Walls and Roofs Limited is in the same business and has not gone up yet, so I will buy it instead.

• My neighbour bought a new BMW with her profits from renovating and selling on old houses. I must be able to do the same.

• Jack Cleever grew Cyberspace Limited into a big company. He is now turning around an ailing old family company. I will invest in that company.

All of these situations are examples of decision making based on a superficial comparison that ignores the base rate.

Summary

The representativeness bias occurs when we use something superficially similar as a basis for a decision. We tend to see similarities where they do not exist or are not meaningful. This leads us to misjudge probabilities and risks because we are ignoring the base rate. Whenever we come across situations in which we have little or no meaningful information about a choice of any kind, we avoid the representation bias by falling back on our common sense and trying to imagine what the mathematical likelihood or probability will be. Where possible we should seek out relevant statistics on which to base the probability.

Strategies

1 Now we are aware of the representativeness bias, we can make it a habit to always ask ourselves: What is the base rate? Developing a habit requires a lot of effort and concentration and is not easy. We could make a note and stick it on the edge of our computer screen: ‘Have I asked myself what is the base rate for at least one thing I am working on today?’ Leave it there for a month and try to make it happen.

2 It is much easier to see representativeness in others than in ourselves. In developing our sensitivity to representativeness errors it can be very useful to listen for them in what is said around us. It may not be a good idea to point it out and lecture others on it, although we might subtly wonder aloud about the base rate by asking how many other examples there are of something used to justify a decision. The main thing is for us to make an effort to recognise when others are ignoring the base rate, because it will help us to start seeing when we ourselves are doing it.

3 We should try to develop a habit of quantifying things. Suppose we want to start a new business. The first step is to find the statistics, which governments keep, of how many new businesses succeed or fail in the first two, five or ten years. That is the base rate. Then look for the reasons why they fail and try to understand and avoid them. In another example, suppose we see a number of newly floated companies doing well and think that it might be a good plan to invest in some. First seek out the facts. In particular, ask: How many new floats in the past have succeeded and how many have failed? Also ask: Is the success to failure ratio the same in any market conditions? Yes, it is hard work, but the great investors do this work and develop judgement skills that are above average. If we invest in ignorance of the base rate, then the market will teach us what it is. The fees the market charges are called losses.