Introduction

Investment psychology is a broad topic across behavioural finance and psychology, it massively affects each and every investment decision made by an investor with or without their consciousness. Hence, it's crucial to know which investment biases are commonly daunting the investors and indirectly account for the irrational decision made by the investors, which leads to the topic of this article, the available heuristic.

Definition of Availability Heuristic

The availability heuristic or sometimes called availability bias is a cognitive bias which drives people in making a decision based on an example, information or recent experience that is readily available to them, albeit it may not be the best example to inform their decision. We have to admit it, as human beings, we tend to believe information that more readily comes to mind is most important. (Tversky & Kahneman, 1973)

Why do Availability Heuristics exist

Humans are born genuinely biased, no matter how difficult we try to keep ourselves objective. Herbert Simon, a Nobel prize winner in behavioural science, who is committed to the field of cognitive psychology introduced the idea of bounded rationality in 1955. (Celia Gleason, 2021)

The theory of bounded rationality indicates that people are not inclined to find out all the necessary information to make a rational decision as limited by time and cognition. This causes us to make choices that are satisfactory rather than optimal. Hence, due to human nature, we tend to make a decision with the most available and relevant information that we have. (The Decision Lab)

How Does It Affect the Investors

The availability heuristic recalls information based on ease of retrieval. The easier you recall something, the more likely you will use it to form and support your beliefs and opinions, such as information that you easily memorized, something that had a bigger impact on you, or events that happened more recently in your memory. Our cognition takes these shortcuts to considerations in the decision-making process. When information is more easily accessible, we naturally believe that it’s more efficient to use that information to make a decision. (Shonna Waters, 2021)

The availability heuristic works to prioritise irregular events based on recency and vividness. A simple example will be a person who recently witnessed plane crashes will make him afraid of flying for a period of time, he most likely will choose to travel by route instead of flight. But in fact, the likelihood of the fatality rate in car accidents is still far higher than the fatality rate in aeroplane crashes.

Investment Example

To illustrate that, we can take Alibaba’s Ant Group IPO as an example. During Ant Group IPO, most of the investors have a positive outlook for the company, their belief came from the fact that it is one of Alibaba’s subsidiaries.

As the investors recalled Alibaba’s success and can use it as an example to run their investment decision for Alibaba’s Ant Group IPO. They believe that history will repeat itself, and the Ant Group’s share will grow in a similar pattern as Alibaba.

This is a typical availability heuristic that uses a past example to make the decision, as they believe the future is similar and linked to the past. But in the end, Ant Group IPO is suspended to date due to Chinese regulators' pressure. Hence, the example exhibits that investors who affect availability bias might cost you a big lesson.

Solutions to overcome availability heuristic in investing

1. Avoid making impulse decisions

As the availability heuristic works as a mental shortcut that tends to skip the logical argument process, hence investors have to realize it and mandatory requires you to have a logical argument based on facts and evidence every time when making an investment decision.

Simply put, when you’re about to make a decision in investing in any stock, make sure you know what you are doing and what are the consequences of the actions. Although it is always difficult to stay objective when analyzing stocks, a good investor should consider all the good and bad news when making their investment decision, instead of neglecting the information that is against their beliefs. (Shonna Waters, 2021)

2. Create your investment checklists

A good investor will always stick to their investment plan, if you are yet to have an investment checklist, you may refer to David Parmenter’s “A Warren Buffet Styled investment checklist”. An investment checklist enables an investor to question their decision through a thorough thinking process that slows down the mental shortcut led by the availability heuristic.

Business Tenets Checklist

1. Is the business understandable?
2. Does the business have a consistent operating history?
3. Is there a big moat around the business (a high threshold of entry)?

Management Tenets Checklist

1. Has the management demonstrated a high degree of integrity (honesty)?
2. Is management rational?
3. Has management resisted the temptation to grow quickly through the merger?

Financial Tenets Checklist

1. Is the return on equity adequate?
2. Has the company had a track record of earnings growth in most years above the stock market average?
3. Are the profit margins attractive (better than the industry)?

Value Tenets Checklist

1. Is the value of discounted earnings greater than the current market value?
2. Have cash flows been based on net income, plus depreciation, depletion, and amortization, less capital expenditure and additional working capital requirements?
3. Has the company been temporarily punished for a specific risk that is not a long-term risk (the market tends to over-punish the share price)?

*The checklists refer to the article titled, A Warren Buffet styled “Investment checklist” by David Parmenter

3. Reasoning up from facts and data

As the availability heuristic tends to jump to conclusions without much reasoning, it is meaningful to retain the thinking process when we make a decision. Bear in mind that our decisions should always be supported by facts rather than assumptions, and prioritise evidence from primary sources instead of people’s opinions from secondary data. (Farnam Street)

The Bottom Line

In conclusion, the availability heuristic is just one of the biases of investment biases, and each bias is the obstacle that hinders investors to gain money or become successful in the stock market. In a word, these mental shortcuts should be discouraged when comes to stock investing, as any mistake an investor made could heavily affect his investment return hence knowing how to navigate through the biases is vital to success in the stock market.

References

• Farnam Street. The Availability Bias: How to Overcome a Common Cognitive Distortion.
• Gleason C. (Nov, 2021). Availability Heuristic and Decision Making
• Katie Canales K. (Jan, 2021). How Ant Group's $37 Billion IPO Dreams Were Dashed.
• Parmenter D. (2019). A Warren Buffet-Styled “Investment Checklist”.
• The Decision Lab. Bounded Rationality, Explained
• The Decision Lab. The Availability Heuristic, Explained.
• Tversky A. and Kahneman D. (1973). Availability: A Heuristic for Judging Frequency and Probability. Cognitive Psychology 5, 207-232 (1973)
• Waters, S. (Oct 2021). The Cognitive Biases Caused by the Availability Heuristic.

Author

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This article is written by Alex Chong Wei Kang, Research Analyst Intern

Alex Chong Wei Kang is a fresh graduate majoring in International Business at University Malaysia Sabah (UMS). Alex onboarded TED Optimus Sdn. Bhd. for 3 months and responsible to research Malaysian listed companies and article writing. He is also a junior research executive in Financial Literacy for Youths: Malaysia, a student-run organization aimed to improve financial literacy amongst youths in Malaysia. He was an in-house author of TED Optimus.