Availability bias causing decision bias.

It is a behavioral finance concept which describes how our environment can shape our perceptions.Let’s go back to 2008-09, wherein many people lost their jobs, economy was under stress and house prices were depreciating from their peak.

Consider an example wherein, Mr Dumb who is unemployed due to slowdown in the economy. This person is less likely to feel an economy recovery when there are signs of turnaround.

Conversely, Mr Smart who lends a great job during same period with decent salary and incentives will see that economy is stable and there is tremendous scope.

These were perceptions built by Mr Dumb and Mr Smart in same period. Similarly, investors build their own perceptions on market performance and get trapped in their thinking. This thinking is called “Availability Bias”.

Let’s look at another example of Availability Bias to get a deeper understanding of this common phenomenon of behavioral finance. On one particular day in 2010, two analysts from one of the recognized institutional research houses decided to examine returns of the companies in Sensex indices for a three year period.

Out of BSE 30 index they separated the top 15 performing stocks into a “winner’s portfolio” and the remaining 15 stocks were considered into “losers portfolio.” They tracked each portfolio’s performance against a benchmark index for next three years.

The results were surprising after completion of three years. It was found that the loser’s portfolio consistently beat the market index, while the winner’s portfolio consistently underperformed.

Overall the difference between two portfolios was almost 20% during the three year time span. In other words, it appears that the original “winners” became “losers”, and vice versa.

What could have happened in last three years both analysts discussed with their team? They found that investors essentially overreacted in both the winners and losers portfolios.

In the case of the loser portfolio, investors initially overreacted to the bad news and value stocks were available at discount price. After few months, investors realized that their pessimism was not entirely justified exaggerated and these loser stock prices began rebounding.

The exact opposite was the situation in winner’s portfolio; initially investors believed there is enough steam for this stock price to move up from current level. But, at certain point the stocks in winner portfolio which was over heated started to cool off.

This example explains availability bias which drives investor decisions toward new information based on press release from company management or economy data; people tend to make opinions which are biased towards data and information that is in vogue and readily available.

Thinking Man Solution’s on “How to Avoid Availability Bias?”

Follow time bound classical advice on investment that the world’s biggest financial gurus have professed. Some of the classical principles being: