When making investment decisions—and in many other situations—heuristics, or mental shortcuts we use to respond quickly, play an essential role. However, these shortcuts can lead to significant errors, particularly when we misjudge risks or assess opportunities inaccurately. A striking example of these cognitive biases emerges when we look at transportation accident data in the United States.
Risk Perception and the Availability Heuristic
An analysis of transportation-related fatalities—including cars, trains, airplanes, and bicycles, as reported by the Bureau of Transportation Statistics—reveals how our perception of risk often gets skewed. Why, then, do so many people believe that flying is the most dangerous form of travel, even though data indicates otherwise? This is where the availability heuristic comes in, making us consider information we recall easily as more relevant. Rare but shocking events, like plane crashes, draw extensive media coverage and stick vividly in our memory. By contrast, car accidents, though frequent, are less emotionally striking and thus hold less immediate weight in our perception of risk.
In finance, the availability heuristic manifests similarly: we’re more inclined to invest in stocks that receive frequent media attention or gain sudden popularity, like the “meme stocks” such as GameStop. Such stocks often become focal points in the market, and if a stock attracts enough buyers, it can trigger a phenomenon known as a short squeeze. This happens when heavily shorted stocks experience sudden and intense buying, forcing short sellers to repurchase shares at higher prices to cover their positions. The dramatic price swings in these situations illustrate how market psychology and media attention combine, leading investors to make impulsive and sometimes high-risk decisions.
.Confirmation Bias: A Subtle Adversary
While the availability heuristic steers us toward what’s most visible, confirmation bias reinforces our beliefs by selectively focusing on information that aligns with our initial ideas, often ignoring data that might contradict them. In the investment realm, this means that if we’re inclined toward a specific sector or stock, we tend to focus only on positive news, overlooking warning signs. This bias can lead to short-sighted choices, devoid of an objective consideration of risk. A recent Cerulli Edge-U.S. Retail Investor study confirms this, noting that nearly 88% of small investors are influenced by the availability heuristic, and 78% by confirmation bias.
Biases Working in Tandem: A Chain Reaction
Cognitive biases often work together, amplifying the overall impact on our decision-making ability. For instance, the tendency to follow others—known as the herd bias—is frequently reinforced by the availability heuristic and confirmation bias. In the investment world, this mechanism leads investors to follow popular trends or widely-circulated recommendations, increasing the likelihood of collective actions that may not align with the real value of assets.
Combating Cognitive Biases in Investing
While it’s impossible to entirely avoid mental shortcuts, recognizing them helps to mitigate their negative effects. The first step is improving financial literacy to make more informed and independent decisions. Furthermore, consulting a financial advisor can help lessen the impact of cognitive biases by providing a more objective, thorough analysis that allows for more measured, rational choices. Awareness of these biases enables us to navigate the investment world with greater clarity, using heuristics as allies rather than mental traps.