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.
Phobias
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.
Availability Heuristic and Money
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.
The Gambler’s Fallacy
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.
Avoiding the Availability Heuristic
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.
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I’ll never forget the day one of my teachers told me that if you want to gamble you might as well take a stock list from a newspaper and throw a dart at it, then invest in the companies you hit. His rationale was at least he stock market returned 105-110% to the overall pool, whereas most lotteries and casinos were much less than that. Interesting perspective anyway (one some mutual fund managers might want to try in order to improve their performance).
Wow, @Ray, I’m really flattered. If you’re interested in this subject, I’d recommend Predictably Irrational by Daniel Ariely–he’s an expert in the subject and a very entertaining writer and it’s definitely accessible for the lay person.
You should write a book about Behavioral Economics for the lay person, Emily.
@Michael, thanks so much for your kind words. I’m also fascinated by this area of study and keep finding it has applications all over my life. It’s helped me to understand why Halloween candy doesn’t last three days in our house and why clutter seems to prevail over order around here, too.
I hope you enjoy the fourth installment–it will be posted tomorrow.
I love these posts about behavior economics! Because it’s hard to be aware of the behavior (or even try to control it) until we understand our human tendencies. We make ‘stats’ work for us and ignore the ones that don’t.
@My University Money I kind of want to try that stock list- dart experiment just to see what would happen!
This is also why casinos post the last 3-6 numbers on a roulette board. People will look at these and believe that they affect the outcome in some way of the next spin (either with a “lucky number” or “a certain number being due”).
I’ll never forget the day one of my teachers told me that if you want to gamble you might as well take a stock list from a newspaper and throw a dart at it, then invest in the companies you hit. His rationale was at least he stock market returned 105-110% to the overall pool, whereas most lotteries and casinos were much less than that. Interesting perspective anyway (one some mutual fund managers might want to try in order to improve their performance).
Oh dear…asking the general populace to deal with statistics…not wise, not wise!
But you are confusing the gambler’s fallacy and the concept of regression towards the mean. Regression towards the mean is a valid statistical concept that says that while a stock may have a phenomenally good or bad week, it return to its mean. Of course, the theory says nothing about how long it has to say good or bad before a new mean is established, but for stocks past performance does provide an indicator of future likelihoods.
I am always reminded of Rosencrantz tossing the coin for 87 when it comes to gambler’s fallacy.
Greed without the backing of reason can lead to bad choices. How else do you explain why people hoard stocks at 75 times earnings with 50% growth?