Availability Bias: How It Messes Up Your Investment Decisions

psych2go.net

psych2go.net

Availability bias is a cognitive bias that leads to decisions being based on information and events that are more recent, that were observed personally, and are more memorable. It operates on the notion that if something can be recalled, it must be important, or at least more important than alternative solutions which are not as readily recalled. Under the influence of this bias, we rarely check the reliability of the information we have readily available nor do we try to search for patterns beyond a time horizon that our memory can serve.

The main reason for Availability bias is that the mind always chooses the path of least effort. Looking beyond what is readily available takes quite a bit of effort on part of our cognitive faculties and so we all tend to avoid it.

The world is rife with examples of availability bias. Let us ask you a question? What causes more death? Shark attacks or falling aeroplane parts? Most people rate shark attacks as more probable than death from falling airplane parts Shark attacks certainly receive more publicity by media than do deaths from falling airplane parts, and they are far easier to imagine You'd be surprised to know chances of dying from falling airplane parts are 30 times greater than the chances of being killed by a shark. Similarly, you have a higher probability of winning a Noble Prize than getting attacked by a Shark.

Similarly, most people think driving a car after being drunk puts them at a higher risk than walking down the road being drunk. Yet, more people die walking on the road than driving the car.

Availability bias is also the reason why demand for travel insurance shoots up just after the reports of a catastrophic natural disaster. The memory of the crash is fresh in peoples’ mind and so they tend to take additional precautions. Over time, this memory fades and the demand comes down to usual levels.

The most influential studies of availability biases were carried by Paul Slovic and his longtime collaborator Sarah Lichtenstein and Baruch Fischhoff. They carried out groundbreaking research on public perceptions of risks, including a survey that has become the standard example of an availability bias. The results were surprising.

  • Strokes cause almost twice as many deaths as all accidents combined, but 80% of respondents judged accidental death to be more likely.
  • Tornadoes were seen as more frequent killers than asthma, although the latter cause 20 times more deaths.
  • Death by lightning was judged less likely than death from botulism even though it is 52 times more frequent.
  • Death by disease is 18 times as likely as accidental death, but the two were judged about equally likely.
  • Death by accidents was judged to be more than 300 times more likely than death by diabetes, but the true ratio is 1:4

Factors Affecting Availability Bias:

Ease of recall- The most important factor that leads to availability bias is the ease of recall of the information. Factors that affect ease of recall are:

Data age- More recent events are easier to recall so a recent train accident, a recent market decline or a recent market crash make us behave in manners we wouldn't behave normally.

Personal experience - Any personal experience makes us form an opinion that tends to stick even if our experience was an exception rather than a norm. An unpleasant experience in a restaurant or a flight makes us form a judgment about the overall service levels of the company.

Intensity of experience: The more intense our experience , the more it sticks to our memory. Not many will in the US forget 9/11 or 26/11 Mumbai attacks.

Vividness of memory: The more vivid our memory the more readily it is available to make us those snap judgments that may not always be right. A recent news report of airplane crash may make us feel that aeroplanes are an unsafe mode of transport.

Frequency: The more frequently an information is repeated, the easier it is to recall. The frequency of co-occurrence strongly relates to the frequency of repetition, such that the more an item-pair is repeated, the stronger the association between the two items becomes. Just because two disparate events occurred together doesn't mean that one leads to another. For example, you maybe flipping coins and every time you flipped a coin after having a glass of milk, you saw a head. The co occurrence of two events­ you drinking milk and you landing a head while flipping a coin, though unrelated may lead you to believe that drinking milk before flipping a coin makes you lucky!

The fFrequency of co occurrence leads to spurious correlations or illusory correlations i.e making associations between two unrelated events. Most of our superstitions are based on these illusory correlations.

Exemplars: Another factor that affects Availability bias is the existence of exemplars. Exemplars are the typical examples that stand out during the process of recall. Suppose, you are to determine the number of men and women in a class by making you read a list of names for 30 seconds. If you are able to recall more common male names, you would think that the class has more male names and vice versa.

Number of examples required and reversal of bias: The number of instances once can recall to support an argument matters a lot. If you are required to give 2 examples to support that you are assertive you will find it very easy. However, if you are asked to give 12 examples, it puts a strain on our memory. As you try to recall 12 instances, you will find it increasingly difficult to come up with such instances. Something interesting begins to happen then. As you find it more and more difficult your mind starts giving you thoughts that you are perhaps not as assertive as you thought you were and soon you reach a conclusion that you are not assertive. This phenomenon of thought reversal because of the mind's inability to come up with enough supporting instances is called the reversal of availability bias. Similarly, surveys requiring the respondents to come up with a large number of improvements that can be made to a seminar just conducted reveal a larger majority of people judging the seminar positively.

Availability Cascades

Sometimes availability bias leads to those feedback loops where available information feeds on itself and grows bigger and bigger. An availability cascade is a self-sustaining chain of events usually started by a media report and led to a mass frenzy. The mass hysteria created by media reports on insecticide contents in aerated drinks a few years ago is a typical example. Suddenly Coke and Pepsi were poisonous to people. People tend to forget that in India, the tap water has more impurities and toxic contents that the aerated drinks.

The recent reports of deaths of 'hapless citizens standing in queues caused due to demonetization' is another example. There is no apparent relation between death and an ATM queue. Though unfortunate the deaths would have occurred anyways because most of those deaths were due to natural causes like heart attacks. When you spend a major portion of your day standing in a queue , then you are more like to get a heart attack in the queue than anywhere else. Its as simple as that. We may sound insensitive but we'd rather be the sole voice of reason mid a media frenzy that creates mass hysteria out of nothing.

Implications of Availability Bias in Investment and Business world

The implications of availability bias are more pronounced in the world of business and investing where people mostly focus on the recent quarterly results and not look at the long term story. It was availability bias at play that made almost every analyst forecast confidently that crude was about to hit 150 dollars /barrel when it crossed 125 dollars . It was again availability bias at play that made almost analyst forecast the price of crude to go below 20 dollars/barrel. Following are some of the implications of availability bias in the world of finance

Euphoria vs Despair The biggest risk of availability bias is the feeling of over-confidence it generates in most investors during bull runs. Whatever stock they choose it goes up and this gives them the feeling that they are born with a golden touch. The media does its bit in talking up prices and suddenly everyone knows someone who made a killing in the last IPO. The availability cascade starts and you have a situation ripe for a crash. Its only when the tide recedes that those who thought had that golden touch suddenly realize that they were not even wearing pants! The inevitable crash then starts another availability cascade that makes many investors throw their towel never to return to stock market again. The investor plunges into despair and every stock comes down without reason.

The intensity of pain of losing the money, the vividness of this memory , the constant reports by media of stocks plunging all create a scary atmosphere and the investor finds it almost impossible to keep his own rational counsel.

 Eg: even stocks like ITC corrected during Lehman crisis. No one asked why would people stop smoking if a bank in US went bust.

IPO returns: many investors start taking a bet on all new IPOs especially during the late stage of a bull run because past few IPOs made a stellar debut. This is a classic case of availability bias and investors forget that 80% IPOs underperform within a year.

Returns claimed by "stock experts": During a bull run you will find many self-styled stock experts dishing out stock tips. Since in a bull market every stock tends to go up, these experts get a lot of following. No one cares to look at their long-term track record. Similarly, many economists are hailed because they could predict the subprime crisis. One event can never be a true indicator of someone's acumen of predicting large macro changes. Investors should understand the power of incentives and look beyond the data being dished out by these experts

Availability bias with halo effect: The deadly cocktail: Most biases do not act in groups with more than one bias distorting our thinking. Many investors just latch on to whatever stock tips is available to them by an ace investor. The Halo effect of the celebrity investor along with the availability bias of a stock name makes the investor believe that it's a worthwhile investment. Alas, this is not the case and the investor loses money.

Another effect of Halo effect + availability bias is when more than one data set is available - like an Investor deciding to look at a particular company more closely just because it is more widely known. Then depending upon what kind of report the investor first reads- a bullish report or a bearish report the investors forms his opinion about the worthiness of the company as a potential investment.

Lessons for the prudent investor

Availability bias has perhaps the strongest impact on an investor because of the plethora of TV channels and investment related tips in the market. Following suggestions should be kept in mind to eliminate the influence of availability bias

Look beyond what is readily available: Don't get swayed by media reports and try to look beyond what meets the eye. While media was gung-ho about the potential of e­-commerce only a few savvy investors looked beyond the startups and looked at logistics companies as a direct beneficiary of the e-commerce boom.

Ask the right questions: whenever your broker tries to induce you to buy or sell by giving you some reason try to figure out how reliable is his information. Secondly, keep in mind that the brokerage firms make money when you trade not when you do nothing, despite the later being more beneficial to your portfolio. Understand the power of incentives Keep in mind the perspective of time: Have a long-term outlook and don't get caught in the frenzy of a bull market or the gloom of a bear market. Warren Buffets advice of being fearful when others are greedy and greedy when others are fearful, though simple, is so difficult to follow because of the effects of availability bias. Remember that marketmoves in cycles and neither a bear market nor bull market lasts forever.

Buying stocks with good businesses and great management at a reasonable price will never let you down in the long run.

A savvy investor is one who knows the difference between reaction and research. As Sir John Templeton famously said: "Avoid the popular. When any method for selecting stocks becomes popular, then switch to unpopular methods."

Know Thyself: More often than not, the availability bias of our emotions plays havoc with their judgments. Whenever in a bull market you start feeling the fear of missing out take a pause. Similarly whenever you start getting scared in a market where prices are continuously falling, remind yourself to not take any reckless sell decision. Use your emotions as a guide to help you make better decisions by being keenly aware of what you are feeling and then disassociating yourself with those feelings.

 The investor checklist: we highly recommend using the following checklist of questions to counter the  effects of availability bias.

  1.  Is my opinion about the future of a company being determined by an external factor like a movie that I watched the effect of a recent memory?
  2. Do I feel confident about my analysis
  3.  Am I currently engaged in another mental task requiring effort?
  4. Is my view about a company being determined by my recent success failure in deciding about another company?
  5. Am I basing my decision to buy or sell because of a feeling fear of missing out (FOMO) or fear of losing?

Availability bias affects almost every aspect of our lives especially our financial decisions. It makes us forget that there is much more to what we think we know. An ability to stand against popular opinion and depend on own counsel rather than what others are saying is perhaps the best way of reducing its effects