"Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years." Warren Buffett

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Representativeness is a human behaviour whereby in order to cope with the myriad information humans are bombarded with every day, we tend to create stereotypes and patterns with which to categorise and make sense of information, often falsely. For example, we tend to think of people as either “good” or “bad” based on a short list of qualities, however in doing so, whilst we may gain speed and simplicity, it is often at the expense of ignoring the more complex reality of the situation. How often do you “size up” a person in a matter of seconds? Just about everybody does.

Put another way, humans assume, often incorrectly, that similarity in one aspect leads to similarities in other aspects. Accordingly, if something doesn’t seem to fit into a known category, we approximate to the nearest category available. Hence, we often tend to adopt false generalisations without being aware that we are doing so.

This can be seen in the world of gambling. If we toss a coin and get heads five times in a row, we incorrectly assume that the next toss is more likely to be tails. However, logic tells us that the chance of tails on any toss is the same as heads… 50%. This is known as gambler’s fallacy. We assume incorrectly because the pattern of alternating coin tosses sits more comfortably with us... it is more representative. In other words, we expect a random process, such a tossing a coin, to yield random looking results… we expect the results to be representative of the process that generated such results. It’s the same way people assume the lottery numbers will be nicely spread out from 1 to 45, whereas the likelihood of the winning numbers being 1, 2, 3, 4, 5 and 6 is just the same as the likelihood of any particular set of nicely spread out numbers such as 4, 11, 19, 26, 34 and 41.

In the world of investing, false generalisations are a dime a dozen. We often put stocks in a similar category as others based on one similarity, when in fact we have by way of a shortcut incorrectly assumed multiple similarities when in fact there are very few. We also tend to form opinions on stocks based on very limited information. Like with people, we may view a stock as “good” because the company’s chairman is the chairman of another successful company, when in fact the chairman may be the only similarity and therefore, categorising these two companies together may be a big mistake.

Many people will assume that because a company is perhaps well known like Telstra, then it must be a good stock. This is the process of over simplifying the decision-making process using limited available information instead of seeking out as much information as possible.

Profile: Warren Buffett

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