Behavioural Finance, Part 3: Availability and Representativeness

Welcome to Part 3 of our Behavioural Finance series. If you’ve missed the earlier parts of the series, you’ll find our Introduction to Behavioural Finance here and Part 2: Prospect Theory and Loss Aversion here.

It seems like every few weeks we hear a story about a big lottery win on the news. We might notice a work syndicate has had a windfall, or maybe the three-week rollover total has finally been won by a lucky ticket holder; or, tantalisingly, the winner of a jackpot three months ago hasn’t yet claimed their prize, which puts us all on the lookout for discarded tickets.

With regular examples of these lucky winners all around us, have you ever found yourself thinking that the probability of a win can’t really be all that remote? I can’t speak to whether lottery organisers have a good grasp of the fundamentals of behavioural economics, but keeping media stories about big jackpot wins in the news will certainly help to sell tickets.

Traditional economists used to assume that investors were all perfectly rational beings, who possessed all the information they needed to make a financial or investment decision – but this isn’t the case. In fact, behavioural economists would argue that when we make choices in real life, we never have every single piece of relevant information available to us. Even if we did, in the context of investing and the ever-changing nature of markets, it would be an impossible task to assess all of our investment options and make a categorically correct decision.

Instead, we make do with our limited understanding of the situation, and we use shortcuts to help us make a choice. Unfortunately, these shortcuts can often include biases that divert us from making the best choices in the moment for what we want to achieve in the future. The availability bias and representativeness bias are two examples of how what we hear about a topic, and how that fits in with what we already think we know, influences how we react to it.

Availability

Behavioural economists have found that the availability of information greatly influences our decision-making. In the case of lotteries, the highly available news reports of jackpots, rollovers and missing winning tickets floating about might leave you feeling like it’s about time the windfall landed in your lap. Of course, the availability of this information does nothing to change the minute odds of winning, and so people regularly overestimate their chances of scooping the big cash prize.

People are very bad at estimating the probability of all sorts of rare events, and we often believe that events happen more frequently if instances are easier to remember. Sometimes, overestimating the likelihood of a certain event is quite beneficial: for example, it’s rare for pedestrians to get hit by cars, and looking both ways before you cross the road helps keep it that way! However, when it comes to investing, gloomy economic news and stories about share price plummets or stock market crashes can have a disproportionate effect on investors’ attitudes.

Access to too much information can encourage a short-term focus and too much tinkering with the portfolio, which can destroy the potential for good returns. This risk can be particularly salient for experienced investors – after all, what information is more available than your own memories? When people have had an experience with a particular investment, they are more likely to use that experience (good or bad) to inform their decision-making process in future.

The ready availability of so much information in our society can be a problem for staying committed to investment plans. At First Wealth, we emphasise the importance of being patient and sticking to the long-term plan, but it’s only human to be affected by news when it comes at us incessantly and from so many different angles. The natural tendency is to withdraw or panic. As advisers, it’s our responsibility to remind our clients that we are in this for the long term, that every era has its stock market ups and downs, and that the best returns tend to be seen by investors who avoid short-term, knee-jerk reactions.

Representativeness

Whenever we encounter something new – an investment, a person, a car, a business, anything – we tend to judge or categorise it on the basis of how closely it resembles a stereotype. Although we’re often not consciously aware of them, we all use stereotypes when organising things into categories and making decisions. Representativeness is a mental shortcut that people use to decide if something belongs to a category on the basis of how well that thing represents the stereotype. For example, if you are introduced to a sportsman who is seven feet tall and asked to guess whether he is a high jumper or a jockey, given what you know and understand about these sports, it’s unlikely you’d guess he rides a horse for a living.

Unfortunately, sometimes we can be misled by stereotypes. When it comes to investments and financial planning, investors can mistakenly classify stocks in terms of supposedly shared qualities with a stereotypical ‘good’ or ‘bad’ investment. Sometimes this approach works, but other times it can leave us holding an investment that isn’t delivering the return we were expecting or causes us to reject an investment that would have paid off.

For example, it would be easy to assume that shares in a successful, globally renowned company represent a good investment. However, this company’s success and future potential are probably already reflected in their share price, so there may be limited opportunities for making significant returns in future.

We also find that many new clients have previously been told to invest in companies who make products they like to use. This strategy is risky, because a popular product can cause the company’s share price to temporarily inflate beyond its ‘true’ value. In other words, the fact that this company seems very representative of the stereotypical ‘good investment’ doesn’t necessarily mean it is more likely to be one.

As financial advisers, we also suffer from stereotyping of our own profession, as slick, brash City-types who are only out to make a quick buck. In the current climate of suspicion of financial institutions, it can be difficult for advisers to win trust. If a client feels like they have been let down – or worse, misled – by a bank or firm, they might be reluctant to get advice again or to fully trust another adviser, which can be frustrating for both parties.

As Professor Brett Kahr points out, finding it difficult to trust an adviser might not be solely related to a client’s financial experiences:

“Thinking about this more broadly, we know that people who have experienced many betrayals or disappointments, perhaps by parents, partners, or friends, can import this sense of mistrust into their financial lives. In view of the widespread nature of betrayal during early-life experiences, which damage our sense of trust, the reliability of the financial adviser becomes deeply important as a corrective.”

Our aim at First Wealth, both with individual clients and as ambassadors of the industry, is to help restore that trust in our profession. We’ve set up a business that proudly rejects City stereotypes, adapting our ways of working to make ourselves more approachable and warmer to clients (for one – we don’t wear suits!). Initially, this break with convention seemed scary, but it has succeeded in removing the barriers between us and our clients, helping to reduce any apprehension, or even fear, of seeing a financial adviser.

We have built our business to advise people not just on their portfolios, but on what their investments can mean for their lifestyles, which provides a more rewarding and fulfilling experience for ourselves as well as our clients.

Questions to Ask Yourself

How strongly do you agree or disagree with the following statements?

• I often buy and sell investments on the basis of stories I read in the news
• I wouldn’t be put off a given investment if I had previously lost money on something similar
• I prefer to invest in things that I know well
• I like to invest in companies whose products I own and enjoy using

If you would like some help in planning your ideal financial lifestyle, please feel free to get in touch.

Next post: The Law of Small Numbers: Gambler’s Fallacy and the Hot Hand Effect.

This document is marketing material for a retail audience and does not constitute advice or recommendations. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.