Why Investors Do The Crazy Things They Do – Concept 7 Overreaction and the Availability Bias

imagesThis is the seventh article in this series where I discuss a concept called behavioral finance, or as I like to call it, why investors do the crazy things they do.

It’s a relatively new field that tries to combine behavioral psychology theory and economics and finance to explain why people make irrational financial decisions.  If you are reading this, and an investor, you have likely used one of these concepts in making your investment decisions.

Concept 7. Overreaction and the Availability Bias
One of the biggest challenges with investing is controlling emotion. Emotion causes an investor to overreact to new information. Market efficiency states that new information is reflected in security’s price instantly. So good earnings should raise the price, and lack of bad news should allow the price to stay there.

Unfortunately, that’s not how it works in reality. New information comes out, investors overreact to that information, and artificially move the price more than it should. In addition, this is only a temporary effect the price movement erodes over time.

The availability bias causes investors to place more importance on recent information, making any new opinion biased toward the latest news.

This happens in real life everyday. For example, you just purchased technology stock recently. Something you may have done many times. Then you happen to watch a reporter on TV explain how incredibly volatile technology stocks are right now (one persons opinion). Although technology stocks might be no more volatile than they have ever been, seeing the report causes you to overreact and sell.

How to Avoid Availability Bias
The best way to avoid getting sucked into the availability bias is by doing your homework. If you actually research your investments, you’ll better understand the relevance and importance of recent news. It will help you to be able to react better. Giving in to emotion, the latest headlines or gimmicks rarely works in investing. Avoid the noise.

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