Availability Bias in Financial Planning
A Crash Course on Availability Bias and Recognizing How It Plays Out in Financial Planning
Learn how intuition can fail you, and more importantly, how you can overcome it when making investing decisions
May 26, 2022
Katie Malone was celebrating her 29th birthday in Puerto Vallarta, Mexico, when she decided to take to the sky parasailing. A few minutes into the ride, she noticed something was wrong; the boat was driving in a different direction than she was flying. Her nightmare ended when she finally crash-landed on an airport runway two miles away and was left with a fractured pelvis, four broken ribs and a collapsed lung.
Now, I was terrified of parasailing way before this story, but this was the nail in the coffin for me. I remember hearing about it on the radio in 2018, and coincidently hearing another parasailing horror story shortly after. I now had two vivid examples to validate my fear. Checkmate, case closed, I was never going parasailing.
The reality, on the other hand, is that parasailing is quite safe. In fact, the Parasail Safety Council reports that out of an estimated 170 million parasail rides between 1982 and 2012, there were 1,800 injuries and 70 deaths. That means there is a 0.001% chance of injury and an even smaller chance of death. However, the ease at which I recall this story anytime someone talks about parasailing trumps those probabilities for me. This psychological phenomenon is known as availability bias, and we’re all susceptible to it. It’s the tendency to lean on information that comes to mind quickly and easily to make decisions about the future.
When we talk about availability bias in the context of parasailing, shark attacks, and lightning strikes, it’s easy to spot how a couple stories can knowingly twist reality and make us believe the risks are significantly higher than they truly are. But if our intuition fails us in these instances, shouldn’t we ask ourselves if availability bias is clouding our judgment in other areas? What about our own abilities? Health care? Business? Financial planning?
The truth is, we all use availability bias as a mental shortcut in decision making. Whether we’re aware of when it’s happening is the question. In financial planning, we see this play out daily. Availability bias is always trying to usurp rationality and guide decisions that have real and significant consequences if made incorrectly. My goal today is to help you see one way that our intuition often fails us in the financial world, and how we can overcome it to make more successful investing decisions. To better understand, let’s take a quick crash course in behavioral psychology.
- In 1973, Amos Tversky and Daniel Kahneman led a study where participants were asked whether more words begin with the letter K, or if more words have K as the third letter. Although twice as many words tend to appear with K in the third position, 70% of participants chose words beginning with K. The reason for this is that it’s much easier to think of words beginning with K than the alternative, thus making us believe they are more frequent.
- In 1983, Tversky and Kahneman revealed another reality of availability bias by asking half of the participants in a study to guess the likelihood that a massive flood would occur somewhere in North America, while asking the other half of participants about the likelihood of a massive flood occurring in California due to an earthquake.
Logically speaking the first scenario has to be more probable; however, participants in the second group gave a higher probability to a flood in California caused by an earthquake. How does this make sense? The second scenario is a familiar event, with a believable cause and effect that is easily imaginable in one’s mind. The generic flood anywhere in North America is ambiguous and gives no frame of reference on likelihood. Therefore, it’s not just ease of recall that leaves us to being susceptible to availability bias, but we can also infer that the more impressionable an event, idea or scenario is, the more likely we are to misjudge its frequency, magnitude, and impact.
- In 1990, our understanding of availability bias was advanced even further in an experiment led by Norbert Schwarz. In this study, Schwarz asked one group of participants to list six instances in which they behaved assertively, followed by a self-evaluation of how assertive they were. Try it yourself. Likely you can come up with six instances, and because of that, you will likely give yourself a decent grade when it comes to assertiveness.
When they replicated this experiment, but asked for twelve instances instead of six, participants’ self-evaluation of their assertiveness dropped significantly. Why? Try listing twelve examples now. You almost certainly will find it challenging to come up with the last three or four. The struggle to provide examples led the participants to question their abilities and believe they were, in fact, less assertive.
To summarize our crash course, we are susceptible to availability bias when:
- It’s easier to recall many examples compared to examples of the alternative (words that start with K vs. words that have K as the third letter).
- We have coherent, impressionable stories stored away in our brains (flood in North America vs. flood in California caused by an earthquake).
- We are asked to list more examples than are easily recalled (how assertive are you?).
Knowing that we all make thousands of decisions per day, and many of those decisions have consequences if made in poor judgment, it is critical to know how we are being influenced by these mental shortcuts. This is especially clear in the world of investing, and even more so during volatile markets where media coverage is turned up full blast. With a greater awareness of availability bias, our hope is that you can take actions to improve rational investment decisions, which in turn will lead to greater life satisfaction. Here are three practical applications from the studies discussed:
- We know we are susceptible to availability bias when it’s easier to recall many examples compared to examples of the alternative.
In what percentage of years is the U.S. stock market down? Most of us probably don’t have an answer that feels readily available and reliable. If we use the S&P 500 as our metric, the answer is 28% of the time since 1926, and 27% of the time since 1992. That number probably seems low if you regularly consume financial news, but as we now know, it’s also surprising to us because of how easy it is to recall market pullbacks. Most of the pullbacks even come with a neat name to help us remember them! Great Financial Crisis, Tech Bubble, etc… But for every historical market pullback or recession, we know that the days spent in bull markets are far greater. Take this chart for instance:
- We are susceptible to availability bias when we have coherent, impressionable stories stored away in our brains.
The five years since 1992 where the S&P 500 ended down more than 5% for the year are all memorable. Three can be attributed to the Tech Bubble and 9/11 from 2000 to 2002, the fourth is the 2008 Great Financial Crisis, and the fifth was related to trade talks with China in 2018. If you had investments during those times, you probably feel a visceral reaction as you relive what it was like to lose 40-50% of your portfolio. You know friends and family who foreclosed on their houses, closed businesses, or got greedy and lost big. Not to mention, you were bombarded with fearmongering daily on your local news. So, when you consider the risk of investing in stocks, or you see a 5-10% pullback, are you influenced by the stories you’ve lived through?
- We are susceptible to availability bias when we are asked to list more examples than are easily recalled.
We know from Schwarz’s research that having to list many examples of something reduces our confidence when it’s not easy to come up with multiple examples. We also know that market timing doesn’t work on a consistent basis, yet we often feel the temptation to try it when things start to go sideways. Knowing this is the case, we should want a mental framework that can talk us off a ledge. If asked to only list one reason why timing the market is a good decision, we may find ourselves overconfident. But if asked to list multiple reasons, we’ll likely see something different.
Take this example of what missing just the ten best days in the market over the last ten years would do to your portfolio:
So what can we learn from all of this? We might not like the negative impacts of availability bias, such as the readily available stories that evoke fear, or the possibility that it’s going to cause us to make a drastically incorrect financial decision; but, on the other hand, by understanding what it is and how to recognize it, we can manipulate it to keep fearful stories from becoming life-altering losses. The problem is, research shows we typically don’t have the self-awareness to overcome this bias on our own. That’s where the Voyage Wealth Architects team can help. The decisions you face encompass your livelihood, your autonomy and independence, your dreams, and your legacy. You’ve worked hard to secure those things. We know the stakes are high, and that minds are easily influenced, but just because something is easy to recall, that doesn’t mean you need to spend time worrying about it. At Voyage, we understand the biases that can undermine a good financial plan, and we’ll provide the partnership and guidance you need to recognize them and then ensure they don’t get in the way of your values and goals.
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