Tuesday, December 28, 2010

Availability Bias

Starting from this week I am going to introduce to my readers the different types of mental bias that will hider successful trading in us. Today’s topic is “Availability Bias”, a behavioural finance theory that is based on Kahneman and Tversky’s famous literature – Judgement Under Uncertainty: Heuristics and Biases in 1974.

According to the availability bias theory, people pay attention to anything in the media that supports their fear and perception and ignore the other side of the story. In short, availability bias makes people less objective when making decisions.

For instance, many people have misconception about investing in the stock market. When asked why they rather put their money in the bank than in the stock market, they said: “Why? Because I don’t want to lose all my savings”.

People typically give too much weight to recent experience and extrapolate recent trends that are at odds with long-run averages and statistical odds. They tend to become more optimistic when the market goes up and more pessimistic when the markets are down. These people probably heard one or two stories about people losing all of their savings in the stock market, but they ignore other facts about the stories – maybe those people invested on speculative stocks or they put all their eggs into one fragile basket. These people do not realise that by doing some research, they can find some safe and sound investment that produce greater returns than the bank rate.

So the next time when you need to make a decision on stocks, remember not to fall trap into this mental mistake, instead we need to apply statistics, reasoning and probability into our thinking.

Happy investing,

Pauline Yong

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