2018 mock question 4-B
If a stock has been going up, but the latest quarterly earning is below expectation.
Someone with the representative bias will sell the stock. Here is the answer key:
Sara’s representative bias is a belief persevance bias in which people tend to classify new information based on past experiences and classification.
Her bias will lead her to overweight the new information of missed earning and lowered guidance, viewing this new information as representative of a long-term trend for the company.
She will therefore most likely sell her shares.
My question is: where is the past experience come into play? She only relied on the most recent information. How does it relate to her past experience?
I may be wrong but as far as I know, representative bias has 2 sections (not sure if the section is the right word for these) - base-rate neglect and sample-size neglect.
The way how I am understanding them is;
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Base-rate neglect - even though the funds have performed well for the last 10 years, if it failed in the last year (most recent), the investor overweighs the recent failure
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Sample-size neglect - a tendency to think small sample represents the population
For this particular question, the company’s profitability has been higher but lower in the most recent quarter.
I believe this relates to Base-rate neglect that I have mentioned above.
Check out 2017 Q5 A.ii> which has very similar concept.
My take on this is that the “past experience” comes in as the past classification of taking the bull trend of the stock to be indicative of a long term trend of the company. With the recent failed quarter results, and with a sample size neglect, she would classify this new information to be indicative of a long term trend.