Representativeness & Gambler's Fallacy
Representativeness Heuristic
Definition: Judging probability by similarity to a prototype.
Error: Ignoring base rates and statistical principles.
Investment Manifestations:
- "This CEO is like Steve Jobs → Next Apple!"
- "Hot IPO → All IPOs are good"
- "5 green days → Stock is 'hot'"
Gambler's Fallacy
Definition: Believing random events "even out" in short run.
Classic Example: Red came up 5 times → "Black is due!"
Reality: Each spin is independent; 50/50 every time.
Investment Examples:
- "Stock fell 5 days → Must rise tomorrow"
- "Market up 3 years → Crash is 'due'"
- "Fund underperformed 2 years → Will outperform now to 'average out'"
Hot Hand Fallacy (Opposite Error)
Definition: Believing random streaks will continue.
Example: "Stock rose 5 days → Will keep rising"
Contradiction: Gambler's fallacy expects reversal; hot hand expects continuation. People use both inconsistently!
Law of Small Numbers
Error: Expecting small samples to reflect population statistics.
Examples:
- 2-year fund track record seems sufficient
- 3 good quarters → "This company always beats estimates"
- Friend made money in crypto → "Crypto is profitable"
Reality: Need large samples (10+ years for funds, hundreds of trades) to distinguish skill from luck.
Combating These Biases
Always Check Base Rates: "What % of companies with charismatic CEOs succeed?" (~10%)
Recognize Independence: Past coin flips don't affect future flips; past stock days mostly independent
Demand Large Samples: 10+ years for investment strategies, not 1-2 years
Statistical Thinking: Use probability theory, not pattern matching
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