R is for Representative Heuristic

The Representative Heuristic is our trick of comparing whatever happens to be under consideration to whatever we can bring to mind. It's an effect of availability, but we can be primed into triggering the heuristic by clever manipulators or not-so-clever psychologists.

Example

The famous example is Linda the librarian:

Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in antinuclear demonstrations. Which of these two alternatives is more probable?

(a) Linda is a bank teller.
(b) Linda is a bank teller and is active in the feminist movement.

So which is it?

Causes

Most people choose (b) because they've been primed by the vague "do-gooder" type description when in fact it is never more likely that someone will be an X and a Y than just an X on it's own, a logical error known as the conjunction fallacy. You're less likely to be a woman and French than you are to be a woman: there are a lot less French women out there than there are women in total. It's another example of base rate neglect - how many feminist librarians are there compared to the total number of librarians?

But generally this is an example of availability: we don't search our entire memories for the most relevant matches, we simply recall one that roughly fits and which we can easily bring to mind: it's an heuristic, a rough rule which usually works but which can sometimes fail. And it's one reason people tend to invest in stocks that are popular, than  less well-known ones, for instance.

Mitigation

You can't really avoid the representative heuristic, but you can mitigate its impact by doing proper research rather than just investing by making superficial comparisons. Classically people invoke memorable past market conditions to predict the future: the Wall Street Crash and the subsequent Great Depression is hauled out every time we have a bit of a financial crisis. Ironically, the fact this is so strongly imprinted on the minds of regulators and politicians everywhere is the best guarantee that it won't happen again.

Don't use lazy mental shortcuts to make important investing decisions. Just because something  reminds you of something else doesn't make it more than superficially similar. Bats aren't birds and most fish aren't fish any more than an elephant is a koala bear.

And also: Behavioral Finance's Smoking Gun
Read more: A Liberal Arts Investor's Reading List

The A to Z of Behavioral Bias