ABSTRACT
Mental shortcuts, also called heuristic simplifications, help us analyze situations and make decisions quickly in our daily life. However, this process often leads us astray when analyzing decisions with risk and uncertainty. Because investing decisions involve substantial risk and uncertainty, our decisions are biased in predictable ways. The representativeness bias causes us to extrapolate the past and assume that good companies are good investments. The familiarity bias causes us to believe that firms we are familiar with are better investments than unfamiliar firms. Thus, we own more local firms and our employer’s stock and few international stocks. Thus, these biases lead to low diversification and higher risks.
