Q What are some behavioral finance issues that pay to understand?
A There are a number of behavioral finance theories, all of which are worth understanding in order to approach investing in the most objective way possible. Two of these are availability bias and representativeness.
Availability bias refers to the fact that when you rely on heuristics, or rules of thumb, to make a decision or form an opinion, there is an inclination to remember more strongly those events that are recalled the easiest. For example, if I were to ask someone whether there were more annual deaths from homicide or stroke in the U.S., they may very well guess homicide.
This could be because of the frequency with which the media reports on these stories and the lack of publicity received by deaths from stroke. In fact, there are 11 times the number of strokes than homicides in the U.S. The fact that
the answer is dictated even somewhat by the availability of information for mental recall is what is known as the availability bias.
Representativeness is essentially stereotyping. An example can be shown through a set of studies performed by De Bondt and Thaler (1985, 1987) showing that stocks that have lost a lot of money for the past three years tended to outperform stocks that made a lot of money the past three years. However, according to De Bondt (1992), analysts' long-term earnings forecasts tended to have biases in the same direction as recent success or failure.
In other words, there was optimism with regard to the analysis of recent outperformers and pessimism in the analysis of recent underperformers. There was a lack of consideration of "regression to the mean." Regression to the mean is a statistical concept explaining how values, over time, tend to regress towards their historical average.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. John C. DeMoss, CFA, serves as president of DeMoss Capital. Submit questions to his attention by writing to Business Editor John Vass Jr., Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by e-mailing him at firstname.lastname@example.org.