We Can't Help It - We Overreact to Recent News
"We tend to judge the probability of an event by the ease with which we can call it to mind."
-Daniel Kahneman
What do you think is more likely; getting killed by a shark or getting killed by a flying champagne cork?
Most people swear that shark attacks are far more common. After all, there are movies made about shark attacks and there's ever a shark sighting near a beach, the media swarm and and sell us the bad news. In fact, champagne corks kill far more people each year than sharks.
That seems weird, right? Why does it make intuitive sense that sharks are very dangerous and that champagne corks aren't even worth talking about? It all comes down to how we recall information from our memories.
Recent Events Are Easier to Remember
Things that happened recently are fresh in our minds. We know they happened because, well, they just happened. Things that happened in the distant past are far more difficult to remember.
Moorhead, Minnesota (right next to Fargo, North Dakota) where I'm from occasionally suffers from severe floods. If you talk to people the year after a major flood, they tend to think that severe floods are very common and are likely to happen next year. If there hasn't been a major flood for a decade, people judge a major flood as being less likely. The closer the flood is to recent memory, the more likely we judge its likelihood.
Similarly, after getting a speeding ticket, many people will slow down and start driving a little slower. Over time, though, as the memory of that speeding ticket becomes more and more distant, people are right back to where they started.
Familiar Stuff Is Easier to Remember
If you were asked to judge how likely it is for someone to get divorced in their 60s, your answer (not the answer) will depend on how many people you know who got divorced in their 60s. If you know several couples who were divorced in their 60s, you will thinks it's common. If you don't know anyone in their 60s who got divorced, you will think it's unlikely.
When you're asked this question, you scan your memories for incidents of this happening. If you can remember some you think it must be likely.
Preferences Matter
Thinks that you know and are familiar with can be further broken down into preferences; things you like and things you don't like. You judge things you like as being more common and things you dislike as being uncommon.
What percentage of people like jazz? How about classical music? If you don't like jazz or classical music you probably think not that many people like it. You don't like it and you aren't weird. Plus, you don't know anyone who does like it, except for that weird uncle nobody talks about.
On the flip side, if you do like jazz or classical music, you probably think a higher percentage of people also like it. You are more likely to hang around people with similar music tastes and that gives you the impression that there are a lot of people who listen to those genres.
We Remember Things That Happened Directly to Us
If something happened to you or someone you love (good or bad), then you think it's far more likely than it probably is. Things that have happened directly to us feel like they are more likely to happen again, or feel like they were likely to happen in the first place, than things that we just read about.
For example, if you were mugged in a particular city or neighborhood, you probably won't visit that city or neighborhood again. Even if the true odds are 1 in 500 chance, if you are that 1, then if feels likely.
What's This Have to Do with Money?
The name for this phenomenon is availability bias, meaning we all have a bias toward retrieving information that is more available. This has a lot to do with our financial decisions. For example, right after a market downturn, many of us think that market downturns will happen with more frequency than they do. Or, media coverage can remind us of the most recent downturn, thus making it more retrievable in our memories. If the news says last year was the worst year for stocks since 2008, we remember 2008 and how we felt then. It doesn't matter that the phrasing is misleading. We retrieve those memories.
If we work for a company or in an industry that is doing well, we judge the long term future performance of our company stock far more positively that we should (as a matter of fact, you should not have a lot of company stock). It is difficult to convince someone in the technology industry that they have too much of their money in technology stocks.
Once we understand how our memories retrieve information we can work to make better decisions. Focus on the long run over the short run, and resist herding, or chasing trends. Seek out a trusted friend or advisor to run decisions past. With all our access to data we can easily fall victim to information overload and forget that we may not be trained, experienced, or objective.
It's easy to believe we are more accurate or informed than we actually are. Keep an eye on the decisions you make and how you make them and you'll see improvements in your money health.
Read Next:
References:
Daniel Kahneman: Thinking Fast and Slow
Michael Lewis: The Undoing Project
North Dakota State University: Flooding Along the Red River of the North
Michael Pompian: Behavioral Finance and Wealth Management
invesorwhiz.com: Availability Bias: How It Messes Up Your Investment Decisions
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