Don't let easy-to-recall information sway your clients' long-term plans.
This is the 11th article in the Behavioral Finance and Macroeconomics series exploring the effect behavior has on markets and the economy as a whole and how advisors who understand this relationship can work more effectively with their clients.
The availability bias is an information processing bias. It's a 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 bias perceive easily recalled possibilities as being more likely than prospects that are harder to imagine or difficult to comprehend.
One classic example of availability bias is the tendency of most people to guess that shark attacks more frequently cause fatalities than airplane parts falling from the sky. However, as difficult as it may be to comprehend, the latter is actually 30 times more likely to occur than the former. Shark attacks are probably assumed to be more prevalent because sharks invoke greater fear and/or because shark attacks receive a disproportionate degree of media attention given their frequency.
In the investment realm, investors will often choose investments based on information that is available to them (advertising, or suggestions from advisors and friends, etc.) and will not engage in disciplined research or due diligence to verify that the investment selected is indeed suitable for their particular situations.
The result of availability bias is that investors may not choose the best investments for their portfolios and may end up with suboptimal results for their goals.
A simple example of availability bias in investing is an investor choosing mutual funds based on those that do the most advertising. Since the information is readily available, some investors may be inclined to invest in the one they've heard of most often, whether or not the fund is good or fits in with their goals. In reality, of course, there are many high-quality funds that do no advertising but could be found via independent research. Because such research may present a burdensome endeavor in the mind of an investor, some simply rely on the most readily available information for their decision-making.
At the macro level, one of the most obvious and unproductive manifestations of the availability bias is the lottery. If people really understood their chances of winning the lottery, they would likely never purchase a lottery ticket. Yet many, many tickets are sold every week. If only these folks would invest this money rather than wasting it on lottery tickets they would be so much better off. Lotteries prey on the bias that people judge probabilities on the basis of how easily examples come to mind. Lotteries are heavily promoted, and when someone wins, its big news. You could be the next winner, right? The odds are very much stacked against you. According to a recent Washington Post article, the odds of winning Powerball are 292 million to 1. Despite these odds, millions of tickets are sold when the pot gets large.
As an advisor, you should be aware that everyone possesses a human tendency to mentally overemphasize recent, newsworthy events. Refuse to let this tendency compromise your advice to your client. The old axiom that "nothing is as good or as bad as it seems" offers a safe, reasonable recourse against the impulses associated with availability bias.
The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.
