You Won’t Get Fooled Again: Understanding the Availability Bias in Investing

You’re no fool. But let’s imagine for a second that a major public figure said something—something false—over and over (and over) again. Regardless of its questionable veracity, is there a chance you’d be more likely to believe the proclamation simply because you’ve heard it often and recently?

Like it or not, the answer is an emphatic “Yes.”

You and I are more likely to believe something is true when it’s readily available—that is, when we’ve heard it frequently and, especially, when we’ve heard it lately. This phenomenon is dubbed the “availability heuristic,” and even though it was discovered and named (by Amos Tversky and Daniel Kahneman) more than 40 years ago, it likely hasn’t caught on in the broader public awareness because its title includes the word “heuristic.”

Nonetheless, the availability heuristic’s power to persuade is not lost on marketers, salespeople, lobbyists and politicians. They use it on us all the time. But let’s explore the errant biases in investing, in particular, that while readily available often lead to sub-optimal outcomes.

Active vs. Passive

The debate rages (and no doubt will continue to do so) over whether active stock pickers are able to beat their respective benchmark indices. The implications seem simple: If fee-charging money managers aren’t persistently outperforming their benchmarks, we likely should not be paying them for underperformance, right?

If you knew, for example, that nine out of 10 active managers failed to beat their benchmarks over the short and long term, would you be likely to put your money at risk trying to find the one that might add value by capturing that elusive alpha? Well, that’s what the numbers say in the Mid-Year 2016 U.S. SPIVA report. Roughly 90% of professional money managers don’t “beat the market.”(Additional studies suggest that today as few as 2% of active managers provide statistically significant alpha.) Yet the vast majority—about 80%—of our dollars in mutual funds alone (not to mention all of the individually and separately managed stock accounts) are actively invested.

Why? Two primary reasons: First, as my colleague, Larry Swedroe, writes, “It’s not that the game is impossible to win” (inspiring hope in the gamblers among us that they’ll be the one out of 10 to beat the market) but “that the odds are so poor that it’s not prudent to try.”

But I believe there’s an even bigger reason for active management’s continued existence, and that it’s rooted in the availability heuristic. When was the last time you saw a commercial for a brokerage firm, bank or insurance company? They’re ubiquitous. I ask because virtually every single one that I’ve seen invites your investment with some variation of active management.

And there may be an even stronger force than the availability heuristic at play here—the self-preservative instinct. Tens of thousands of Americans make their living convincing people that they are (or can find) the needle in the investing haystack. That can be a powerful draw indeed to fearful investors unacquainted with the data.

Annuities

Fewer people make their living selling annuities, which are investment vehicles created by insurance companies, but their motivation to move products is even greater thanks to some of the highest commissions in financial sales. That’s why it has often been said that “annuities are sold, not bought.”

I must add that there are valid uses for certain types of annuities in certain situations, but many, if not most, of the uses encouraged by much of the industry have been academically invalidated. Their proliferation seems grounded in the fact that they are so eagerly made available.

Compounding the effectiveness of the annuity sales pitch is that they are often presented as instruments that protect an investor’s principal, some even claiming to offer the upside of “the market” without its downside. Despite its too-good-to-be-true ring, the theory of loss aversion—that the pain of a loss is twice as powerful as the joy of an equal sized gain—leads many hopeful investors down a road of contractual complexity, uncertainty and illiquidity.

But with academics and much of the media sending a current of condemnation, insurance companies (and various intermediaries who share in commission overrides) need to create a perpetual cycle of availability while reminding their salesforce that they’re doing the right thing. I’ve seen this at work, in person, at a lavish annuity conference where the attendees were knighted as “the safe-money experts.” Early and often.

Life Insurance as an Investment

Similarly, the draw of high commissions leads many to tout the investment benefits of life insurance. A thoughtful reader implored me to consider that whole life insurance can be manipulated to offer a better investment alternative than a 401(k) or IRA. For that, I blame those who’ve pounded this twisted logic into the investing public, all while dangling a very attractive carrot.

Conclusion

As consumers and investors, it’s helpful to defend ourselves with the same behavioral psychology the securities industry is using to sell things to us. And in this case, better understanding the availability heuristic also means better understanding ourselves.

This commentary originally appeared September 30 on Forbes.com

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© 2016, The BAM ALLIANCE

Tim Maurer, CFP®

Tim Maurer, CFP®, is a Wealth Advisor at Buckingham and also serves as our Director of Personal Finance. Tim’s second book, co-authored with best-selling author, Jim Stovall, is The Ultimate Financial Plan: Balancing Your Money and Life. He is a CNBC contributor and also writes weekly for Forbes.com. He is a graduate of Towson University.

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