A cascade of bad news or good news
Let’s say there is a tragic plane crash in your region with a large number of fatalities. You can be sure that many people will decide that plane travel is unsafe and avoid it, at least for a period of time. The truth is that plane travel is extremely safe and the tragic crash has not changed that.
Behavioral psychologists call this the Availability Heuristic. Kahneman describes the Availability Heuristic as a short cut we take when we want to estimate the frequency of something. We retrieve instances from our memories. If the retrieval is ‘easy and fluent’ we judge the frequency to be large. Frequency is judged by “the ease with which instances come to mind”. (Kahneman, Thinking Fast and Slow, 2011)p.129. The ease of coming to mind is the Availability.
Are investors susceptible to this? You bet they are. Let’s look at some examples.
What’s the risk that stocks will fall 35% from recent highs? Of course investors have vivid memories of the crash of 2020 and some with still have seared into their memory the brutal plunge of 2008. Vivid memories and recent events will come to mind easily and many investors will judge the risk to be very high. In point of fact there have only been 11 times in the last 100 years that stocks have fallen 35% from a recent high.
Making your reputation
The long term reputation of a CEO or stock market pundit can be made or unmade by one or two great or horrible years or one or two seemingly prescient calls. In reality a remarkable short or even a medium term record may be of little significance. As Kahneman puts it: “A few lucky gambles can crown a reckless leader with a halo of prescience and boldness.” (Kahneman, 2011)p.204.
If several banks have just reported record breaking profits of billions of dollars or massive record losses this may well lead investors to form a long term view of banks as particularly profitable or unprofitable businesses.
The Availability Heuristic also works in reverse. We tend to underestimate the frequency of bank failures or sovereign defaults when there haven’t been any for a long time and none come readily to mind.
Media and pundits
The most fascinating side of this issue is the role of the media. Kahneman comments: “The lesson is clear: estimates of cause of death are warped by media coverage. The coverage is itself biased toward novelty and poignancy. The media do not just shape what the public is interested in, but also are shaped by it.” (Kahneman, 2011) p.138. What he’s saying here is that feedback loops emerge. The media try to attract eyeballs and carry and shape stories for their poignancy. This attracts eyeballs which thereby shape the media coverage.
It is no doubt true that investors’ perceptions of risk in investing are similarly shaped by the media and high profile commentators who have made a career not based on their investment wisdom but on their ability to dish out to the investing public trenchant and provocative comments (not necessarily wise) about what the public at that moment is interested in.
Indeed, Kahneman feels there is the risk of this going too far. He says: “An availability cascade is a self-sustaining chain of events, which may start from media reports of a relatively minor event and lead up to public panic and large-scale government action.” (Kahneman, 2011)p.142. The Availability Cascade may well contribute to both ‘irrational exuberance’ and a cascade of negative feelings and beliefs that can lead to public fright and panic. Indeed, the Availability Heuristic in the broader community may have some role to play in the feedback mechanisms that ultimately lead to bubbles and panics.
In a 1985 paper by Werner De Bondt and Richard Thaler and published in the Journal of Finance, titled ‘Does the Stock Market Overreact?’ the authors hypothesized that stock market investors overreact to new information, whether or not the news is good or bad.
Niall Ferguson has written: “If the financial system has a defect, it is that it reflects and magnifies what we human beings are like. As we are learning from a growing volume of research in the field of behavioral finance, money amplifies our tendency to overreact, to swing from exuberance when things are going well to deep depression when they go wrong. Booms and busts are products, at root, of our emotional volatility.” (Ferguson, 2008)p.13.
Warren Buffett says: “People are habitually guided by the rear-view mirror and for the most part, by the vistas immediately behind them.” (Buffett W. Fortune Magazine, Dec 10, 2001).
Barton Biggs puts it this way: “All investors by nature are conditioned by their memories. If they have only been investing for a short period of time and don’t have a lot of combat experience, they are particularly vulnerable to what has just happened to them. It is very important not to fall into the attractive trap of extrapolating the most recent past into the future. If you do, it is like steering a sports car up a mountain road, with a steep drop on one side, by peering through the rear-view mirror.” (Biggs, 2006)p.167.
So what to do about it
To avoid the danger of overreaction we need what Daniel Kahneman calls ‘risk policies’. I call them gap-to-edge rules meaning that by using them faithfully they can help you to avoid the behavioral gap and develop a behavioral edge.
Gap-to-edge rules for this post:
Gap-to-edge rule: Educate yourself about the pervasive impact of the Availability Heuristic.
As with so many behavioral biases, the road to salvation comes from a combination of study and hands on experience. The problem with the Availability Heuristic, as with many other behavioral biases, is that they work without us realizing it. Reading Kahneman is a good start.
Gap-to-edge rule: Always take time to step back and get perspective – frame broadly.
Perspective is a good word to describe the best antidote to this bias. It is the same as broad framing we discussed earlier. The Availability Heuristic can cause us to overreact to new information or dramatic events.
We need to ensure we have enough information to reach well supported conclusions. With experience, investors will learn to see how Mr. Market is over reacting to current news and dramatic events so as to be able to take advantage of other investors’ weaknesses caused by the Availability Heuristic.
Gap-to-edge rule: When evaluating management don’t be fooled by very recent success or some high profile win.
Gap-to-edge rule: Ignore ‘doom and gloom’ and ‘new age’ pundits completely.
Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction. This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
To read more deeply on investment psychology see Part 2: Human Foibles and Investment Decision Making
Specifically Chapter 9. Great Investors and Market Psychology
Chapter 10. The Behavioral Gap
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction
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