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Abdin et al

Representativeness Heuristics And Investment

Decision: Findings from Individual Investors’ Survey
Syed Zain-ul-Abdin1, Usman Islam2 and Hassan Raza2
1
The Islamia University of Bahawalpur, Bahawalpur, Pakistan
2
The University of Lahore, Pakistan
zain.naqvi4824@gmail.com

ABSTRACT
This research investigates the representativeness of heuristic-related biases
that influence the individual’s decision in the stock market. This research is
conducted by four biases related to the representativeness heuristic: base rate
neglect, sample size neglect, conjunction fallacy, and gambler fallacy. This
research employs the survey data of 142 individual investors from the
Pakistani stock markets. Techniques of comparative analysis and multivariate
analysis were employed to perform the analysis. The finding of this study
confirmed the individual investor’s decision is influenced due to sample size
neglect and conjunction fallacy because of the representativeness heuristic.
Other biases didn’t have a significant impact on the research. For example, an
individual investor assigns an event’s probability with the most similar
representative outcomes. Behavioral finance offers a mechanism to study the
effect of heuristics and provides advice to avoid biases while using the
heuristics.
Keywords: Representativeness Heuristic, Base Rate Neglect, Sample Size
Neglect, Conjunction Fallacy, Gambler Fallacy, Behavioral Finance
INTRODUCTION
In everyday life, we make some decisions consciously or unconsciously.
Most people consider decision-making simple, but when we talk about
financial decisions, people consider themselves in a complex situation. Like
we all are more conscious when we make an investment decision. Decision-
making is choosing what we want, considering its outcome compared to
alternatives, to achieve the desired goal. Wang and Ruhe (2007) categorize
decision-making with defined strategies into four heads: Intuitive, Empirical,
rational, and heuristics. This paper focuses on heuristic decision-making
using five strategies to make an effective decision. Five strategies are principle
(relies on scientific theories), Ethics (stands on philosophical belief),
representative (based on the rule of thumb), Availability (Based on readily
available information), and Anchoring (Relies on their justification). These
strategies (intuitive, empirical, and heuristics) declared that something is
beyond rationality. This beyondness launched a new era of research in the

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field of finance called Behavioral finance. Behavioral finance is the study of

investor behavior toward money with the basic grounded rule on that how
the investors behave while traditional finance grounded the rule on that how
investor “should” behave. In the behavioral finance, heuristics is defined as
the common rule of thumb that investors make for easiness. Kahneman and
Tversky (1972) introduced three heuristics representativeness, availability, and
anchoring. This paper tries to cover the representativeness of decision-
making. Representativeness heuristic related biases are one of the most
common in the human decision-making. Investors used this to make an
investment decision. Representativeness is a common rule of thumb described
as assigning the probability of an event with the most similar representative
outcomes (Kahneman & Tversky, 1972).
Kahneman and Tversky (1972 & 1984) proposed some biases that are
resulting from representativeness heuristic named base rate and sample size
neglect, conjunction, and gambler fallacy. Base rate neglect leads the investor
to focus on irrelevant information on which decision is made. Moreover, this
is also called base rate bias and base rate fallacy. It is the most important
bias that investor should consider while making an investment decision. Thus,
to address the phenomenon, this paper uses the small version question of
Kahneman and Tversky (1972).
Sample size neglect is bias committed by investors when they heavily
assign the probability of the small sample, based their decision on this and
fail to examine the sample size accurately for the investment decision. Further,
this is also called sample size fallacy and insensitivity sample size. Therefore,
to address the phenomenon, this paper holds the question of Kahneman and
Tversky (1972). Conjunction fallacy refers if the investors violate the basic
principle of probability due to representativeness heuristic. Conjunction
fallacy is defined in many ways by different researchers who believe that
conjunction differs in logic, language and many another way with relating
to error (Politzer & Noveck, 1991). This paper considers the definition of
Kahneman and Tversky (1984) as it describes the meaning of extensionality.
Hence, to clear this phenomenon, this paper rolled the small version of an
example of Linda as a question. After understanding the basic picture of study,
we move on the main point of the paper.
The basic purpose of conducting this research is to find out the impact of
representativeness heuristic related facets on the investment decision of the
individual investors. This paper leads the reader to understand these points:
To investigate the relationship among representativeness heuristic and
investment decision of individual investor. To investigate which facets more
powerfully influence investment decisions of individual investor. Ascertain

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the extent of representativeness heuristic involved in Pakistani Stock

Exchange (PSX).
This study provides the guideline to that individual investor who relies
on representativeness heuristic when making an investment decision. For the
authors, it is important because we can understand the behavioral finance
theories. Financial investors can use this study to advise their investors that
are more reliable and free of biases. This study investigates to find out the
impact of representativeness heuristic investment decision of the individual
investor in the Pakistani stock markets. Most of the prior studies show this
impact with single or two facets, but author collaborates these four most
important facets (Base rate and sample size neglect, Conjunction and gambler
fallacy) that influence their investment decision. The studies that judge
heuristic in the Pakistani stock markets is very few. This paper based on
quantitative method uses primary data. Data is collected with the
questionnaires administrated in the individual investors. The regression
analysis was used to analyze the collected data from the individual investors
to predict the behavior of investor toward the specific heuristic. The rest of
the paper is divided into four sections. Section II covers the related literature
and hypotheses development. The methodology of the study is elaborated in
Section III. In section four, findings of the study are present. In last section
conclusion, recommendation and summary are shown.
Literature Review
In the life of social animals, there is a lot of problems and issues that are
not defined, so people often make some shortcut to make a quick decision
and these shortcuts cover most of the complex situation and ignore the other.
This Ignorance leads the investor to deviate from logic, probability, and
rational choice theory. Most of this kind of deviation in the decision or
judgment is known as cognitive biases. In cognitive biases, researchers are
trying to found how the investors think. In thinking investor mostly make a
mistake in probability judgment. In Behavioral finance field, the
representativeness heuristic is one of the most crucial factors, which described
the probability judgment regarding mistake by the investor in the decision-
making. Representativeness was defined by the Tversky and Kahneman (1971)
representativeness heuristic is making when the activity or event have some
essential aspect related to its parent collection and elaborate some salient
feature of the process by which it is generated. In the presence of
representativeness bias investors overestimate their ability to judge the
likelihood event and as a result neglect the base rate, sample size and other
cognitive bias like conjunction fallacy and gambler fallacy.

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In some certainty, Base rate fallacy is based on representativeness which

leads the investors to ignore the “base rate” information regarding the event.
The base rate is the comparative ratio with which an event occurs. Base rate
fallacy results, when investors basis their judgment on the similarity of
person and represent the classification under consideration (Ginossar & Trope,
1987) For example, you attempt to determine the value investment, and
Investment in Company A by contextualizing the fund is familiar and easy to
understand their sorting scheme. Investor considers the Company A is “value
Stock” and haul conclusion about the investment performance (risk and
returns) based on that scheme. This judgment makes a reason to ignore many
of the related variables which could be important for determining the
successful investment (Pompian, 2011). Kahneman and Tversky (1973) has
done an inspirational work on it by conducting a series of experiment and
interviews; the Famous experiment was done in psychological domain,
processing personality tests to 30 engineers and 70 lawyers, all are an expert
in their field at two different approaches (one group of subjects identical
instruction). He found that when subjects have description information (even
though the information had nothing to do) they ignore the base rate and thus,
this shows that investors are committed to base rate fallacy.
Base rate fallacy describes when subject pays insufficient attention to the
base rate. Kahneman and Tversky (1984) elaborated the example of Linda
and insensitivity of base rate. Subjects were asked to judge whether the man
was most liable to be a nurse or a professional tennis player. For instance, If
the subjects were answered that he was most likely to be a tennis player than
they were committed to base rate fallacy.
In Sample size neglect, when investors access the probability of the
investment outcome, much time is neglected to accurately examine the sample
size of the data on which they rely their decision (Pompian, 2011). Investors
heavily believe that small sample represents their population to the same
extent as a large sample. This phenomenon is called “law of small numbers”
(Kahneman & Tversky, 1972). In the law of statistics, this phenomenon is
considered a banteringly because in the law of statistics it is believed that
larger the sample size, larger the average to near the population. This belief
reinforces under the assumption of local representativeness. Kahneman and
Tversky (1972) argue that local representativeness harms the assessment of
randomness of the investor. If a coin is tossed sometimes, the results are shown
as HTHTHTHT; Coins do not generate a randomly representative result
because the result is shown in too well order. In the law of sample size
investors wrongly believe that small size is representative of the population
and base their judgment on that sample size. The famous question of the
Kahneman and Tversky (1972) addresses this phenomenon,

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question on sex ratio and hospital. Subjects were asked to set whether it was
much liable that 60 proportions of the children born at a small hospital were
higher than the probability of the same event at a large hospital. A respondent
who answered that boys are born in high percentage in the large hospital has
coded an insensitivity of small size or law of small size.
In the rationality of human reasoning, conjunction fallacy is considered a
hot topic in the discussion (Stich, 1990). The representativeness heuristic leads
the investor to neglect the basic properties of the probability. Extensionality
(Bourgeois-Gironde & Giraud, 2009), In simple extensionality describes the
event that holds the identical outer properties are comparable and investors
make a judgment based on the irrelevant information as defined that is titled
extensionality violation (Bourgeois- Gironde & Giraud, 2009). To study the
conjunction fallacy, we show the small version of lenda question proposed by
Kahneman and Tversky, (1984). They proposed an eight alternative while in a
small version two alternative is present. Participants were informed that Linda
belonged to a feminist. The subject was asked to access what is the probability
that lenda work in a bank or what is the probability of the Linda works in a
bank and is active in the feminist movement. Kahneman and Tversky (1984)
state in his research that subjects judge the conjunction (works in the bank &
active in feminist movement) more as compared to works in bank alone.
Probability theory prescribes that probability of conjunction (bank and
feminist) must be less than or equal to the probability of being works in a bank.
The debates are not over, it a very crucial topic in the human reasoning and
decision-making. Most of the researchers argue that conjunction error to some
extent is due to the elusive language factors, such as tacit wording or relating
to the meaning interpretation of “probability” (Fiedler, 1988; Politzer &
Noveck, 1991). Hertwig, Benz, and Krauss (2008) and Mellers, Hertwig &
Kahneman, 2001 explained the different meaning of the conjunction fallacy
with natural language Experiment “and.”
Tversky and Kahneman, (1971) Proposed that investors are committed to
the gambler fallacy due to the representativeness. Survey of Kahneman and
Tversky (1972) showed that people are committed to the gamblers fallacy. Sun
and Wang (2010) show this effect with the time pattern or different
composition. Amin, Shaukat and Khan (2009) found that gambler fallacy
effect the investment decision of the investor in the Lahore stock market. Jim
Loy (1996) study the gambler fallacy with conducted an experiment and found
that people are prey to gambler fallacy in one way to another. Clotfelter and
Cook (1993) examined the gambler fallacy in lottery game with analysis of
data. Shiller (1999) researched the field of behavioral finance and traced that
overconfidence, gambler fallacy, and overreaction is

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the main identified biases that make a reason to suffer the theory of market
efficiency.
Decision making is one of the most important activities in every step of
life, especially when we are deciding the money. As you know, people are
more conscious about the money. In [investment] decision-making investors
are evaluating their decision with available alternative investment scheme to
acquire the desired return (Eisenfuhr, 2011). Decision-making is a complex
task because of numerous factors that influence decision making such as
Representativeness Heuristics are one of the most important factors in
probability judgment which effect investment decision of the individual
investors. Tversky and Kahneman (1971 & 1983) and Kahneman and Tversky
(1972 & 1984) proposed that with the representativeness heuristic, investors
committed some common fallacy in making an investment decision such as
base rate neglect, sample size neglect, conjunction fallacy and gambler fallacy.
The above-explained literature proposed the below- mentioned framework and
showed the proposed Hypothesis for the study.

Representativeness Heuristic

Base Rate Neglect

Sample Size Neglect
Conjunction Fallacy Investment Decision
Gambler Fallacy

Figure 1. Theoretical Model of the Study

Hypothesis 1: Representativeness Heuristic impact on the investment
decision of individual investor.
Hypothesis 1a: Base rate neglect impact on investment decision.
Hypothesis 1b: Sample Size neglect impact on the investment decision.
Hypothesis 1c: Conjunction fallacy impact on investment decision.
Hypothesis 1d: Gambler fallacy impact on investment decision.
The Demographics variables are much important to consider, and it cannot
be invisible for the study purpose. In demographics, we have considered the
gender, age, and education. These specifications of demo- factor may be
important to influence the investment decision. This article shows the
representativeness heuristic and its committed error (base rate neglect, sample
size neglect, conjunction fallacy and gambler fallacy)

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relationship with the investment decision of individual investor. In simple,

how the probability judgmental (representativeness) error effects the
investment decision.
RESEARCH DESIGN AND METHODOLOGY
This research is conducted on primary first-hand data, and all the data
was gathered through well-structured questionnaires. The questionnaires are
made up of four items that are consisting of error done by representativeness
heuristic (base rate and sample size neglect, Conjunction and gambler fallacy).
Questionnaires measurement from representativeness heuristic is taken from
Kahneman and Tversky (1972 & 1984) papers. The population of the study is
the investors of the stock market in the country age from 20 above with
minimum qualification of matriculation. The simple random techniques are
used to collect the sample from the stock market. The 150 investors are
randomly selected as a sample from a stock market for the study to ensure
the unbiased sampling. The 142 sample was collected out of
150. The questionnaires are consisting of closed-ended question which makes
the investor of accessing the answer easily and in brief time. In the field of
behavioral finance, questionnaires are considered the best source to find out
the behavior toward the investment decision in the stock market.
The main aim of the study is to find out the effect of biases of
representativeness heuristic on the investment decision of individual investors.
Hence, to complete this study and find out the effect of biases of
representativeness heuristic, this paper analyzed the data by using the
regression analysis with SPSS 20.
RESULTS
This research is conducted in two stages. In the first stage is a comparison
of study variables with the help of comparison two means and one-way
ANOVA. Comparison of Base Rate, Sample Size, Conjunction Fallacy,
Gambling Fallacy, and Investment decision concerning Gender, Marital
Status, Age, Qualification and Years of working experience in the stock market
based on their means.
H 0 : mM = mFM (1)
H 0¢: MmS= m
(2)
H 0¢: m18-29 = m30-41 = m42-53 = m³54
(3)
H 0¢: mPG = mG = mUG (4)

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H 0¢: m1-5 = m6-10 = m11-15 = m³15 (5)

According to Table 1, it is observed that there is no significant difference
between the averages of BR, SS, CF, GF, and ID with respect to gender, the
result is quite similar according to marital Status but we can see that there is
a significant difference between the means of GF as a significant value is
<0.05.
Table 1: Mean Comparison of Gender and Marital Status
Gender Marital Status
Base Rate 0.71 0.18
Sample Size 0.69 0.85
Conjunction Fallacy 0.36 0.22
Gambling Fallacy 0.48 0.03
Investment Decision 0.39 0.08
With the help of one-way ANOVA Table 2 is completed and it observed
that there is no difference between the means of BR, SS, CF, GF and ID
concerning qualification and years of experience in Lahore stock exchange.
At least one pair is significantly different from age for an investment decision.
‘
Table 2: Mean Comparison of Age, Qualification and Experience
Age Qualification Experience
Base Rate 0.64 0.44 0.85
Sample Size 0.66 0.89 0.57
Conjunction Fallacy 0.21 0.34 0.51
Gambling Fallacy 0.95 0.38 0.86
Investment Decision 0.04* 0.63 0.21
Table 3 shows that means the difference between ages of 18-29 and 30-
41 years is significantly different (p<0.05), while others have approx. Same
averages.
In the second step, the multi-regression analysis was run to examine the
influences of biases on investment decision. The model summary of this
research model shows that representativeness heuristic has only 26.8%
explanatory power to explain the dependent variable which is investment
decision of individuals. The research model of this study does not show the
major impact of representativeness heuristic on investment decision.
Therefore, there are some other facets exist in the field to explain the
investment decision of individuals. In statistic, R-square used to predict the
model fitness.

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Table 3: Least Significant Difference

(I) Age (J) Age Mean Difference (I-J) Sig.
18 –29 years 30 – 41 years -0.25* 0.01
42 – 53 years -0.16 0.25
30 – 41 years 18 – 29years 0.25* 0.01
42 – 53 years 0.09 0.50
42 – 53 years 18 – 29years 0.16 0.25
30 – 41 years -0.09 0.50

ANOVA result values of the study independent variables (Base Rate,

Sample Size, Conjunction Fallacy and Gambler Fallacy) and dependent
variable investment decision of individual value is 0.00 at the 4 degrees of
freedom. This result shows that the model of this study is significant because
t value is greater than 1.96 and p-value are less than 0.05 at 95% confidence
level. The relationship between an independent and dependent variable can
be depicted like as:
ID= β0+ β1BR+β2SS+ β3CF+ β4CF (6) ID= 2.4+ 0.07(BR)-
0.183(SS)-0.153(CF)-0.9(CF) (7)
Where, ID= Investment Decision, X1 to X4 represents the components of
representativeness heuristic that is the independent variable in this study.
Base Rate (BR), Sample Size (SS), Conjunction Fallacy (CF) and Gambler
Fallacy (GF) represent X1 to X4 respectively. Thus, to validate the worth of
these four facets, it is necessary to analyze separately. The t value of X1 to
X4 components is following, base rate -0.39, sample size 4.68, conjunction
fallacy 2.35 and gambler fallacy 1.43.
After analyzing all the facets individually, results found that only two
facets are significant. Sample size and conjunction fallacy found t value greater
than 1.96 and p-value less than 0.05. Therefore, Sample size and conjunction
fallacy have a strong impact on investment decision.
Rests of the variables are not significant because it does not fulfill the
statistical criteria. Therefore, investor’s decision influenced by two biases in
the stock market named Sample size and conjunction fallacy. Individual
investors make their decision based on a small sample. Further, investors
also neglect the basic principles of probability when making an investment
decision. Thus, this study concludes that these two facets of representativeness
heuristic have an impact on investment decision of the individual. Rests, of
the facets, are rejected because it has not significant t value.

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Table 4: Causes to Representativeness Heuristics and Investment

Decision
Coefficients Prob.
Base Rate 0.07 0.47
Sample Size -0.18* 0.04
Conjunction Fallacy -0.15* 0.03
Gambling Fallacy -0.9 0.09
Notes: *represents significant at 95 level of confidence, R2 26.8%
Since the significant value of ANOVA is <0.05 so we reject H0 and accept
H1. Therefore, the model is significant. The coefficient of determination is
R2= 26.8%, which means independent variables (Base rate Neglect, Sample
Size Neglect, Conjunction Fallacy and Gambling Fallacy) are explaining
Investment decision by 27% approximately.
DISCUSSIONS AND CONCLUSIONS
This research reports the survey about the biases related to
representativeness heuristic that influences the decision of the individual
investors in the Pakistani stock markets. This research found that sample size
neglect and conjunction fallacy are the major reasons that affect the individual
decision. Individual consider these biases because they assign the probability
to the events with the most similar representative outcomes. Like in sample
size neglect and conjunction fallacy, an individual used representativeness
heuristic to judge the outcomes.
Therefore, this study shows that heuristic is good but in rational ways. If
heuristic, far the rationality it leads to biases. As like, this study found that
investors neglect sample size and rely on conjunction fallacy because of
representativeness heuristic. With the help of this paper, investors access the
biases of representativeness heuristic. Before deciding, investors should do
some proper research and used heuristics in a rational sense. Behavioral
finance is the hot topic in the Finance field and especially for the stock
market performance. Individual investor’s performance is based on their
decision. Earlier researchers and financial managers measured the performance
based on the rationality method such as risk and returned but with the passage
of time they felt that something is more, which makes a reason to deviate the
asset price to deviate their fundamental value. Behavioral finance answered
this question. Behavioral finance has two building block limits to arbitrage
and psychology. Psychology block further stands on two pillars named belief
and preferences. Author strive to approach the single topic of the belief named
is Representativeness heuristic.

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This paper based on the primary data which were collected with
questionnaires from the Pakistani stock market. To evaluate the most common
heuristic effect on the investment decision, this paper test the
representativeness heuristic related biases in the Pakistani stock market as
introduce by Kahneman and Tversky (1972). Behavioral finance expert used
this heuristic to show the impact on investment decision. The test was
completed with a randomly selected investor from the Pakistani stock markets,
using regression analysis. At all levels (individual, institutional, investment
manager, financial advisor) investors should be aware that behavioral factors
affect their decision making when they are busy in the trading on the floor of
the stock market. So, an investor could use their information, education, and
research to make an effective investment decision. This paper focuses on the
concept of representativeness heuristic and its related biases or errors that
effect the decision of the individuals in the stock market. This study shows
that sample size neglect and conjunction fallacy strongly impact on the
decision of individual investors. Behavioral finance theories provide further
and more deepen understanding to identify heuristics related biases and errors.
Limitations and Future Research Directions
This study is only a part of behavioral finance; it covers the only single
part of behavioral finance that is representativeness heuristic. This topic is
more specific that shows the relationship of representativeness heuristic and
investment decision of individual investors. For studying this topic, the reader
must have some basic know-how about the behavioral finance.
Individual investors should advise managing their portfolio to be free of
bias with conducting the proper behavioral analyze before making an
investment decision. Financial Advisor should advise their investors more
reliable after understanding the behavioral biases. The stock market analyst
should use this before circulating the information regarding the stock market
in the Pakistani stock market for the public which effects the investment
decision-making. The researcher can use this for better understanding the
theories of behavioral finance and concept about the stock market. The
researcher can enhance this paper in the shape of large sample size and
approach the professional manager.

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