Need help in understanding the first part of the answer in the attached example. The below is my understanding.
“If the analyst exhibits base rate neglect (which is a form of representativeness), he would continue to consider his categorization as 100% correct and wait for growth stock to revert”
However the example explains the answers as if "base rate neglect " and “sample size neglect” are not forms of representativeness leading to different answers.
Doesn’t look like base rate neglect & sample size neglect are form of representativeness. Quick google search shows that base rate neglect is a bias whereby people neglect existing knowledge - meaning heavier focus on the most recent information (even in the question, it says “focusing on the recent results”).
Therefore #1 and #2 would result in different actions taken by the analyst. #1 - analyst focuses on the recent downturn and ends up selling XYZ. #2 - Representative bias so don’t care about the recent downturn and believe in past stellar growth of XYZ resulting in no sales.
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- If the analyst suffers from base-rate neglect (ignoring the base of long history of being a growth stock) and sample-size neglect (again, the majority of historical data indicatates it being a growth stock), he/she will ignore the history and focus on limited, more recent info (LY revenue / stock price) to arrive at a decision. Here he/she would believe that stock characteristics have changed from growth and hence would recommend a sell on stock.
- Now this is the other way round! Here the analyst believes that growth classification as representative (i.e. being correctly classified) and hence will ignore the LY’s results and recommend a buy.
About your interpretation, if analyst suffers from base-rate neglect, he/she won’t consider the history (whether correct/incorrect isn’t thought of) and would just focus on recent news/ results and consequently giving a recommendation on the latter. So your inference would be incorrect. Hope you got my point here.
Now coming to the last sentence of yours, and referring to Q2 (which is BTW a very weird way of drafting a question); here the analyst focuses solely on “growth classification” that was initially done and doesn’t take into account the recent results (which may have some important guidance that could say that growth will moderate henceforth, etc.). In this case, he would recommend a buy.
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