Shortly after Hurricane Katrina devastated New Orleans, insurers reported higher interest from clients in other parts of the country in homeowner’s coverage for catastrophes like floods and earthquakes. In early 2003, following three years of big losses in the U.S. stock market and just as the market was about to take off on a renewed bull run, investors were dumping stock mutual funds at a high rate and buying into bond funds.
These are both examples of a cognitive bias known as “salience” or “availability.” It means that we tend to attach a lot of importance to recent events or events with which we are familiar. This is a dangerous bias for investors because it can lead them to overestimate or underestimate the odds of market trends or occurrences, and can cause them to do the exact opposite of what they should do in order to make money. Do you suffer from this bias?
Try this question: Of these two unlikely causes of death, which is more common: dying after being attacked by a shark, or dying after being hit from something falling from an airplane. Shark attacks, of course, get big headlines, partly due to our primal fear of predators. However, it is a lot more likely that someone will be hit by jet refuse and die than a shark will kill him or her. You just don’t hear about the falling junk deaths as much. A similar example involves murder, a crime that always grabs headlines. The average person often places death by homicide higher on the list of leading causes of death than it actually is.
This bias can cause us to look at recent events and incorrectly assume they will continue indefinitely. If the stock market is going up, as it was in 1999, we assume more gains to come; if it has been going down, as in early 2003, we are pessimistic about its prospects. Investors have to work to control these instincts and instead rely on reason, history, and statistics to test their feelings and bolster their strategies. For instance, as gloomy as the markets and the world looked in February 2003, a long-term investor who looked at market history would have realized that markets eventually turn upward and recover. It might have prevented the investor from selling and given him the courage to stay the course long enough to enjoy gains once again.
