Let’s try a little experiment. Make a list of all the words you can think of that begin with the letter R. Now, come up with a list of all the words you can think of that have R as the third letter in the word. Based on your lists, which is more common — words beginning with R or words with R as the third letter?
If you said words beginning with R, you’ve just fallen victim to the availability heuristic. This phenomenon describes how our brains assign more probability to an outcome that we can more easily think of. It’s much easier to come up with a list of words beginning with R, so our brains believe that R words MUST be more common. But it’s simply not true.
We see the availability heuristic all the time when it comes to common phobias. People are often very frightened of air travel, despite its overwhelming safety, because every plane crash makes national and international news. But those same phobics drive cars daily, despite the fact that statistically, driving a car is a much more dangerous mode of travel. It’s easier to imagine a plane crash because we know about every single one of them from the news — but you don’t hear a great deal about the 100+ car fatalities that occur every single day.
This effect of behavioral economics is the reason why individuals play the lottery and gamble, despite the fact that both of those activities are likely to cost them money with no payout. If you can imagine what it would be like to win, then your brain makes it feel as though that scenario is not only possible, but probable. And each time big winners in any form of gambling are featured on news and human interest stories, it makes it even easier for our brains to think the big payout could happen to us.
A related phenomenon is when you believe that something must happen because it’s “due” to occur. For example, if you toss a coin 15 times and it comes up heads each time, you might feel pretty confident in betting that the 16th toss will come up tails. But the statistics for each toss are still 50/50. The previous tosses have no effect on the future.
Investors “playing” the stock market can make similar mistakes. For example, some investors will buy into stocks that are in the 52-week low on the theory that they are “due” to go up. Others might avoid buying stock that’s currently on fire, fearing that the good times can’t possibly last. But in both of those cases, there is more going on. You truly are gambling with your money if you believe that everything evens out every time.
To combat the gambler’s fallacy, you need to look at your stock choices (and coin tosses) rationally. Each independent event has its own odds — regardless what your brain might be arguing.
Anecdotes are the currency of this phenomenon. Every time you hear of a lottery winner, a 100-year old smoker, or a kidnapped child, you are adding to your brain’s store of available outcomes, whether or not those outcomes are truly likely. And since those outcomes appeal to our emotions, they will stick in our minds.
If you are about to make a decision based on fear or greed, stop yourself and ask if your emotional response has any basis in statistics. It’s highly unlikely that you will win the lottery, overcome the health hazards of bad habits, or know a child who is abducted. So don’t place so much emphasis on those possible outcomes.
So far, we’ve covered anchoring and lost aversion. Next week, we’ll finish up our look at Behavioral Economics by examining how instant gratification can lead us astray.
Tagged as: Investing, Money Beliefs, Money ManagementView the original article here
