A few weeks ago, I read an article in the Wall Street Journal about people who had opened up their very first investment accounts just to get in on the Facebook IPO. One man they profiled had purchased $10,000 worth of stock, borrowing $5,000 of it from his mother. Clearly, for him, this was a major investment, so it seems likely he felt this was a sure bet. It also seems likely that he’s kicking himself today, as the value of the stock has dropped almost 25% since its May 17 IPO.
This poor soul, like so many others, failed to judge risk accurately, and no doubt there are myriad reasons for that. But I’d like to suggest that one critically important factor in this story is Facebook’s ubiquity and its starring role in so many people’s personal lives — what psychologists might term the “availability bias.”
Availability bias is the mental rule-of-thumb whereby we call to mind our personal knowledge of a topic in order to work out how important it is. It’s the reason so many people overestimate the danger of flying in airplanes or of having their children abducted, and underestimate the risk of getting cancer from lack of sunscreen or getting in a car accident. Airplane accidents and abductions are big news; they are memorable and easy to call to mind, so we overestimate their importance.
Facebook is likewise vividly top of mind for many people, who use it so frequently and so very personally. This meant that Facebook loomed larger in investors’ minds than it deserved to, given the facts. Rather than compare the benefits of a wide set of possible investments — like other individual stocks, or bonds, or index and other exchange traded funds — people selected among the much smaller set of highly familiar investment choices.
Availability bias distorts business investments in the same way, particularly when corporations seek new growth. In deciding where to allocate new-product or new-business development funds, they all too often view their core or high-profile markets as the safest bets only because they are familiar. Sure they’ve been told “Invest in what you understand.” But is what’s familiar really what they understand?
Rebecca Waber is a manager at Innosight.