The availability bias of investors. Or: Why you shouldn’t use a map of Paris in Nairobi

Harald Schützeichel

When investors are confronted to an investment decision in a company in a developing country, they are often subject to a fatal incorrect evaluation: in the absence of own practical experience with the set-up of companies in developing countries, they draw on experience and assessment patterns they know. But these come usually from companies in developed countries or from other industry sectors. And this frequently yields the fatal result that investment decisions are made based on wrong pattern of decision.

Behind it are two different errors in reasoning which are long-known in psychology: first, the risk of overestimating the own experience and to think it is also applicable in completely different contexts. For example, when a successful entrepreneur in Europe believes that his experience is sufficient to start a business in Uganda. Instead of looking more closely, situations will quickly be sorted based on existing thinking and experience patterns.

In case of investors in the off-grid field, this error in reasoning is often exacerbated by the availability bias: the judgment is thereby significantly influenced by how available examples of similar events in human memory are. Events which we very easily remember seem to us, there-fore, to be more likely than events which we can hardly remember. Researchers tested the availability effect on investors’ reactions to analyst recommendation revisions and found that positive stock price reactions to recommendation upgrades are stronger when accompanied by positive stock market index returns. Similarly, research has pointed out that under the availability heuristic, humans are not reliable because they assess probabilities by overweighting current or easily recalled information instead of processing all relevant information.

An investment decision is always a decision with many unknowns. In such cases, people quickly revert to decision patterns by other investments. This is in principle comprehensible – only in this case, fatal because the requirements are completely different. It’s as if you were in Nairobi and you have forgotten your city map. Casually you find in your suitcase a map of Paris – and think: better any than no map at all.

This misconception is even more reinforced if the environment acts in the same way: that is, when all other investment managers as a matter of course use the map of Paris, although they are in Nairobi. In this way, wrong decisions will be sustained by the information environment.

But how can you avoid this error of reasoning? Team up with people who think differently than you. People with very different experiences. And respect that your experience can be right and still not universally valid. Only then, you will have as investor the chance to make a meaningful substantiated decision. This is especially true for decisions to invest in a developing country. Open your eyes – and you will notice that your map has little to do with the reality.

 


 

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