Behavioural Finance: Overreaction and Availability Bias

You travel on a particular road to work everyday morning and yesterday you saw an accident happen right before your eyes. What would your reaction be? You will begin driving carefully. Even if you don’t if you tell your family or friends about it, they would advice you to be careful on the roads.

Has the number of accidents increased suddenly? No. It is the same for the past few years. They should have advised you long time back and not just after the accident you saw. Why is it? Because of something called Availability Bias. People tend to judge things and act based on the most recent information – be it news that really happened or even opinions of others which might be false. After a few weeks have gone by, you would go back to your original driving style. As long as the event is fresh in your eyes, you would try to act based on that.

How does it affect investors?

Whenever some bad news comes out about a company, everyone tries to get out of the sinking ship as quickly as possible. This causes the stocks to fall to dangerous levels. But in real the bad news might not be that bad to cause such a huge percentage fall in prices. This works equally well for the good news too. All investors want to get in the stock based on the latest good news and drive up the prices more than its value. This is completely opposite of the Efficient Market Hypothesis – at least in the short-term.

There has been a research done on stocks in the New York Stock Exchange, where they picked 35 good stocks and 35 bad performing stocks into two portfolios. Over a 3 year period, they found that the bad stocks portfolio consistently beat the market index and the “good stocks portfolio” consistently under performed.

This shows that investors overreacted to the bad news and drove the stock prices down a lot. Similarly they overreacted to the good news and drove the stock prices all the way up. Over a long time period, this averages out and the real value of the stock comes out.

Overreaction

This affects not only investments in stocks, but also people buying Mutual Funds or ULIPs because the agents showed how big the returns were in the past.

How to avoid Availability Bias?

As always do your own analysis and research before making any decisions. Don’t listen to the talking heads in the various financial TV or media. It is usual for the media to over-hype things because that is what gives them money. Remember never make investment decisions when you’re emotional. And remember what all Mutual Fund companies say at the end of their advertisements? “Past performance is not an indicator of future performance”.

Have you ever overreacted to any news and realised later that it was stupid? Leave your experiences in the comments below.

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