The behavioral decision literature contains a body of work known as heuristics and biases. When psychologists use the term heuristic they mean rule of thumb. When they use the word judgment, they mean assessment. The major finding of heuristics and biases is that people form judgments by relying on heuristics, and that these heuristics bias their judgments and produce systematic errors.

This chapter describes some of the key studies that have been conducted by psychologists of a particular heuristic known as representativeness. Although there are many heuristics that affect financial decision makers, during the first several chapters of this book, attention is focused on representativeness. There are two reasons for doing so. First, representativeness plays a prominent role in financial forecasts. Second, proponents of traditional finance often criticize proponents of behavioral finance for a lack of rigor in applying psychological concepts. The argument here is that behaviorists select heuristics to explain empirical phenomena after the fact, but that the choice set is so large that it becomes possible to explain any phenomenon after the fact.

In order to address this issue, attention is focused almost exclusively on representativeness for the first section of this book. The discussion of representativeness begins with a review of key contributions in the psychology literature, and then describes how representativeness has been...