In theory, managers use the relationship between risk and return to make capital budgeting decisions and to value securities. In practice, managers appear to rely on representativeness when forming judgments about risk and return. In doing so, they are prone to view the stocks of good companies as representative of good stocks and to believe that risk and return are negatively related.

Representativeness, reinforced by the affect heuristic, leads managers to hold erroneous beliefs, associating higher returns with large-capitalization growth firms than with small-capitalization value firms. Representativeness also appears to lead managers to hold the erroneous view that the relationship between the one-year equity premium and future volatility is negative.

Representativeness leads financial executives, individual investors, and Wall Street strategists astray in their estimates of the market risk premium. Financial executives and individual investors are prone to hot hand fallacy, whereas Wall Street strategists are prone to gambler’s fallacy. Representativeness affects Wall Street analysts, leading them to succumb to gambler’s fallacy in their return forecasts for individual stocks. Gambler’s fallacy also appears to influence executives’ insider trades, leading them to sell shares in their firms after a year of high stock price appreciation, and to hold or purchase shares after a year of low stock price appreciation.

The majority of corporate financial managers report that they use a single discount rate when making capital budgeting decisions. Almost half report that they do not adjust discount rates to reflect the manner in which differences in project risk impact differences in project expected returns.