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How Thinking
Affects Investing

Representation Bias

In general, one of the best ways to predict what is likely to happen in life is to ask yourself what happened before under similar circumstances? For example, when we press on the brake, our car slows down; when we press on the accelerator, the car speeds up.

The tendency to assume that similar circumstances will lead to similar outcomes is an important heuristic, one that is particularly useful because many of the details of day-to-day life are highly predictable. Using our past experiences to predict the future enables us to take care of ourselves and to keep ourselves safe.

The prediction heuristic is surprisingly powerful when it comes to understanding other people. For instance, if you want to predict what someone you know will do in a specific situation, all you have to do is remember how they responded in similar situations. For example, let's say that each time you forget your anniversary, your spouse gets upset and pouts. What do you think will happen if you forget it again?

Because we are human, it is easy to assume that the stock market is influenced by predictable forces, capable of acting in ways that are familiar to us. The market, however, is not at all like the day-to-day world; nor does it experience human emotions or have a personality. When we apply this type of thinking to the stock market, the valuable prediction heuristic quickly leads us astray and becomes a dangerous cognitive bias, which we call REPRESENTATION BIAS.

The truth is, whatever happened in the past to the price of a stock does not indicate what is likely to happen in the future. No matter how similar the current circumstances seem to resemble patterns we think we remember, the belief that we can use the past to predict the future is nothing more than representation bias, and will almost always let us down with a thud.

Harley's Rule of Investing #2

When you are investing,
the past does not predict the future.

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