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Investing: Look beyond the latest

May 25, 2009

In the previous article on 'commitment bias', we discussed how the desire to be consistent with one's past actions creates a trap for analysts and investors. In this article, we shall examine another tendency called 'availability bias'. What is 'availability bias'?
We often have to estimate the likelihood of an event in our everyday lives. For example, when is the next bus likely to come? Is it likely to rain today? We often rely on our recent experiences - the fastest available source of information - to estimate the probability of the event. We do not sift through years of records to arrive at a conclusion. It would be too much trouble and for the most part, the available information is good enough.

The reason for this tendency is easy to understand. Quick decision making was critical for the survival of our early ancestors. Earlier humans had to often rely on their experiences in making intelligent guesses. Today when it comes to stock picking, however, the availability bias can lead to irrational behavior if recent experiences happen to be misleading indicators of future.

Examples

  • Health issues: We often assess medical risks, such as heart attack, among a particular set of people by thinking of such occurrences among our acquaintances. Similarly, we justify poor lifestyle choices like smoking by recalling how someone's grandfather was a chain smoker but lived long.

  • Accidents: If we were in a car accident recently, we would drive extra cautiously for the next month. However, as time passes, we are likely to resume driving like our old selves. Similarly, although plane crashes are rare events, statistically speaking, they seem very likely because of their dramatic impact.

  • Overreaction to news: Investors over react to news because it makes that information more available in their memory. Media tends to report the exceptional occurrences. But we do not balance it out by studying complete information and end up believing that these events are the general rule. Hence, we tend to overreact to both bubbles and panics in the stock market.

Avoiding the availability bias in stock picking

  • Admit: The first step in dealing with biases is to admit their presence.

  • Investment process vs. on the spot decisions: Instead of picking stocks on the spur of the moment, we should have an investment process. The process should generate multiple alternatives and examine the threads of reasoning carefully. This way, we won't rely on the latest available piece of information but the most representative one.

  • Study long term trends in business: Memory is not always a good guide to probabilities in the past. Investors should be keen students of business history. For example Warren Buffett is known to read old annual reports of companies going back several years. During the earlier part of his career, he would visit libraries to read old newspapers in order to develop a more balanced perspective. Even today, when he uses examples, he covers large periods of time instead of this quarter or the next.


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