The Availability Heuristic Explained

Behavioral Finance
Risk vs. Volitility
Sarah F. Roach, Vice President

Most investors would like to think they’re logical and objective in assessing important situations and choices, but … research in behavioral psychology and finance indicates that logic doesn’t always govern people’s actions.  One way in which investors get in their own way can be explained by the “availability heuristic.”

The term “heuristics” refers to a variety of mental shortcuts we all use to arrive at conclusions without completing detailed analyses.  “Availability” is one of these shortcuts, and in many situations it serves us quite well.  Specifically, humans find it much easier to bring dramatic events to mind than mundane ones—in other words, make them mentally available.  By responding to these images, we’re able to react quickly to danger or avoid encountering it.  However, whenever we subconsciously decide that an event is likely just because we can easily picture it, we may be letting the availability heuristic adversely affect our judgment.

For instance, some years ago there developed a worldwide mini-panic regarding “mad cow” disease, even though it was never a particularly common illness.  Widespread fear developed as a result of vivid mental imagery rather than logical risk.  Similarly, the image of a plane crash comes more readily to mind than the thousands of flights that occur each day without incident, leading some to conclude that air disasters are more common than is actually the case.  At the other extreme, anyone who buys a lottery ticket thinking that a big win is likely—as seen on TV—isn’t acting logically.

In the world of investing, success develops via a long summation of small changes in portfolio value.  From one day to the next, there’s simply not much meaningful movement to witness, and it’s hard to link these unremarkable days into a clear image of how a portfolio is doing.  This is the mundane nature of successful investing.  It’s far easier to picture dramatic market events—aided in no small part by media sensa­tionalism.  When an investor comes to believe that “dramatic” is the same as “likely,” he or she may not act in a way that supports long-term portfolio growth.

Many investors have achieved remarkable investing success despite some dramatic economic conditions (recessions, high inflation, etc.).  History and logic both indicate that periodic, inevitable days, weeks and months of declining market prices should not invariably call to mind dramatic mental imagery, nor are they worthy of the intense attention routinely given them on TV and online.  On the contrary, if you recall the chart we included in last month’s letter, during the past 88 years, 86% of the months occurred during bull markets, not bear markets.  It would serve most investors well to make the availability heuristic work in their favor by visualizing the long-term investment success they can achieve despite—and sometimes because of—inevitable price drops. (Think “buy low.”)  A steep bear market may be easy to bring to mind, but it is typically only a temporary interruption in a long-term upward trend.