“Why do fools rush in?” How availability bias can shape your investments

“Fools rush in where angels fear to tread.” —Alexander Pope

“Why do fools rush in?” Maybe they suffer from availability bias, a simple rule of thumb or mental shortcut that causes people to estimate the probability of an outcome based on how prevalent or familiar that outcome appears in their lives. People exhibiting this kind of information processing bias perceive easily recalled possibilities as being more likely than prospects that are harder to imagine or difficult to comprehend. They rarely check the reliability of the information readily available, nor they search for patterns beyond a time horizon that the memory can serve.

If I were to ask you what causes more death between shark attacks or falling airplane parts, you would rate shark attacks as more likely than death from falling parts. That is because shark attacks certainly receive more publicity by media than do deaths from the latter, and they are far easier to imagine. However, you would be surprised to know that the odds of dying from falling airplane parts are 30 to 1. Indeed, even the probability of winning a Noble Prize is still greater than being attacked by a shark!

Another instance at the macro level is represented by lotteries since they exploit people judging probabilities based on how easily examples come to mind. If people were really understanding their chances of winning the lottery, they would likely never purchase a lottery ticket. Yet a huge number of tickets is sold every week.

Factors Affecting Availability Bias

Availability bias is fueled by many endogenous (cognitive) and exogenous factors. Of the endogenous ones, the most important is the ease of recall of the information, which in turn is driven by data age, intensity and frequency of the (personal) experiences, and vividness of our memory. On the other hand, exogenous factors comprise of how much and how often certain information is spread by the news. As a consequence of exogenous factors, availability bias can become availability cascades, i.e., a self-sustaining chain of events usually started by a media report and led to a mass frenzy.

Implications of Availability Bias in Investments

Availability bias can alter investors’ habits, leading them to pick not the best investments for their portfolio and with suboptimal results for their goals. An example of this are investors choosing mutual funds based on those that do the most advertising. In fact, since the information is readily available, some investors may be inclined to invest in the funds they have heard of most often, without analyzing if a certain fund fits within their strategy. However, many high-quality funds do little advertising but could be found via independent research, but such research may be costly, hence some investors simply rely on the most readily available information for their decision-making.

However, the biggest risk of availability bias is the feeling of over-confidence it generates in most investors during bull runs, putting said bull on steroids because investors think the surge is permanent. The media plays its own part in this, and suddenly everyone knows someone who made a killing in the last IPO or with a certain stock. One consequence is that many investors start taking a bet on all new IPOs, forgetting that more than 80% of them underperform within a year. Whatever is dominating social media and the news can influence investors’ opinions and decision-making, potentially outweighing any reasonable underlying economic fundamentals. This is, in part, how bubbles are created.

Large voices in the industry, many of them self-styled stock experts, only fuel availability bias. Since, during a bull market, nearly every stock goes up, these experts get a lot of following with no one caring to look at their long-term track record. One event can never be a true indicator of someone’s acumen of predicting large macro changes. The halo effect of celebrity investors along with the availability bias of a stock name makes some investors believe that it is a worthwhile investment. Regrettably, this is not the case and investors lose money.

Furthermore, availability bias increases volatility since investors tend to overreact to the latest news and buzz. Availability bias helps explaining in part how r/wallstreetbets managed to game the stock market by leveraging the internet and social media to drive GameStop (GME) on a rollercoaster ride from a price of around $17 at the beginning of January to a record high of $469.42 on January 28.

Suggestions for long-term investors

We have seen that availability bias clouds judgment and affects almost every aspect of our lives, especially our financial decisions, therefore avoiding this bias is of fundamental importance for long-term (prudent) investors.

First of all, prudent investors should look beyond what is easily available, which means conducting their own research and not getting influenced by media reports. As Sir John Templeton famously said: “Avoid the popular. When any method for selecting stocks becomes popular, then switch to unpopular methods.“

Moreover, having a long-term outlook means not getting caught in the frenzy of a bull market or the gloom of a bear one, since they do not last forever. 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. Buying stocks with good businesses and great management at a reasonable price will never let you down in the long run.

Finally, keep in mind that the brokerage firms make money when you trade not when you do nothing, despite the latter might be more beneficial to your portfolio in certain times. So, whenever your broker tries to induce you to buy or sell by giving you some reason, try to figure out how reliable his information is.

References:

Lanoie A. , “Understanding Availability Bias When Investing”, Forbes, Mar. 23 2021, https://www.forbes.com/sites/forbesrealestatecouncil/2021/03/23/understanding-availability-bias-when-investing/?sh=1b837eeb3d18

Pompian M., “How the Availability Bias Can Derail Investing Outcomes”, Morningstar, Jan. 18 2018, https://www.morningstar.com/articles/843819/how-the-availability-bias-can-derail-investing-outcomes

“Availability Bias: How It Messes Up Your Investment Decisions”, Investorwhiz, Dec. 05, 2016, https://sarita-pandey.squarespace.com/investment-basics/availability-bias-how-it-messes-up-your-investment-decisions