The cognitive bias known as the availability heuristic is a kind of mental shortcut our brain can take through the weeds of our memory when we’re making decisions or predictions in uncertain situations.
This bias can have big implications for investors, particularly where it intrudes on our perceptions of risk. So let’s take a closer look at how the availability heuristic works and consider some ways to keep it under control.
Available and aware
A large body of research has shown that when something is easy to remember, people often misjudge how common or probable it is.
One key study by the psychologists Daniel Kahneman and Amos Tversky presented multiple examples of how this might work.1 In one experiment, they asked their subjects to listen to two lists of names: one with 19 famous women and 20 less-famous men, and one with 19 famous men and 20 less-famous women. When asked to recall what they’d heard, the subjects remembered 50% more of the famous names than the less-famous ones on average. However, in both cases, they also guessed there were more famous names on the lists than less-famous ones, which was wrong. Well-known names were easier to remember, but also somehow easier to over-count, or at least over-remember.
In other words, it seems that in some cases our minds seize on information that is readily available (hence the availability heuristic) and then we settle instead of digging deeper. When information is easy to remember or top of mind, we tend to overestimate how representative it is. The trouble is that ease of recall isn’t a substitute for rational thought when it comes to making decisions.
The availability heuristic can pose particular challenges for investors because it can throw off our ability to judge probability and risk. Extensive research has shown that people often overweight the likelihood that statistically rare things might happen.2 The availability heuristic appears to have a role here, in ways that could encourage excessive risk taking.
For example, one study showed investors who think they could be making a get-in-on-the-ground-floor investment in a stock destined for stardom—say, the next Google or Apple—may be willing to take a large position and pay a high price in exchange for the highly unlikely possibility that they could get exceptionally rich.3 Below average returns are the more likely result.
The availability heuristic could be an explanation: Superstars stand out precisely because they are so rare and therefore receive a lot of attention. That makes them easier to recall, which can trick us into thinking such investing opportunities are common—and therefore a more tempting target for our investing dollars.4
Implications for investors
As with any potential bias, prevention usually starts with awareness and a rigorous interrogation of your assumptions and forecasts.
With that in mind, here are some ways investors can keep the availability heuristic at bay:
Be willing to dig deeper. Before committing to an investing idea, think through alternative scenarios and be extremely critical about judging probabilities. Maybe you’ve found an interesting stock, but how likely is it you’ve stumbled on the next Apple?
Ignore the noise and focus on your goals. This means resisting the urge to make major changes to your portfolio just because people are talking about some new investment. Think about those who jumped into speculative cryptocurrencies because of a fear of missing out, only to lose money when prices started to tumble. What other people in the market are doing shouldn’t matter. What matters is that you’re working toward your goals in ways that allow you to sleep at night.
Be realistic about your risk tolerance. Your recent experience in the market is unlikely to be the best guide to how much risk you can stomach in pursuit of your goals. For example, if there hasn’t been a big drop in the market recently, you may not fully appreciate how you would react to a sudden 10% decline, simply because you have no recent examples to draw on. On the other hand, if you have just suffered through a sharp drop, you may find yourself overestimating the probability of a repeat occurrence and become too risk-averse. Again, the goal is to be rigorous when thinking about probability and risk, and to minimize the distorting influence of recent events.
Make sure you have a diversified portfolio. When reviewing your portfolio, resist the temptation to change your allocation based on the recent performance of particular assets. While your recent returns may be more vivid in your mind—and are therefore tempting material for the availability heuristic—they aren’t a guide to the future. Remember the saying: Past performance is no guarantee of future results. So make sure you understand what each asset class is doing and that the mix matches your target asset allocation. Schwab’s investor profile questionnaire can help you determine your profile and match it to an appropriate target asset allocation. If you need more help, call 800-355-2162 to be connected to a Schwab investment professional.
1Amos Tversky and Daniel Kahneman, “Availability: A Heuristic for Judging Frequency and Probability,” Cognitive Psychology, 1973.
2Nicholas Barberis, “Thirty Years of Prospect Theory in Economics: A Review and Assessment,” Journal of Economic Perspectives, Winter 2013.
3Nicholas Barberis and Ming Huang, “Stocks as Lotteries: The Implications of Probability Weighting for Security Prices,” American Economic Review, 2008.
4Nicholas Barberis, “The Psychology of Tail Events: Progress and Challenges,” American Economic Review: Papers & Proceedings, 2013.
What You Can Do Next
- Listen to more episodes of Choiceology™, a podcast about the psychological traps that lead to expensive mistakes.
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