Why does Google’s success make you want to invest in high-tech?

The availability heuristic

In order to make judgements, individuals are helped by simple facts which are easily brought to attention and from memory. The judgements are biased by this immediately available information, if not totally determined by it. The availability heuristic, documented by Tversky and Kahneman (1973, 1974)[i], encapsulates the general principle by which individuals evaluate the probability associated with an event as a function of the ease with which examples of such an event come to mind. For example, they asked 152 English-speaking individuals whether words beginning with K or those with K as the third letter were more numerous. (Words with less than three letters were excluded). Out of the 152 persons questioned, 105 opted for words with K in the first position, while in fact these are half as numerous as words with K in the third position. This result is explained by the greater ease with which one can find examples of words beginning with K as compared to words with K in the third position. Other examples can be found in daily life. The driver who has just witnessed an accident will drive more carefully, for the time being, even though he knows that the probability that he have an accident has not suddenly gone up. Only the subjective probability that he associates with being involved in an accident has temporarily increased. In financial matters, the heuristic of availability can play a role when the individual reasons by analogy rather than by logic to come to a decision and take a position. This is notably the case during initial public offerings when investors participate in introductions just because previous introductions of “similar” firms have gone pretty well in the recent past. There was a temptation to buy shares of EDF (the French electricity utility) at its appearance on the French Stock Exchange only because the introduction to the Exchange of GDF (the French gas utility), which was perceived as a similar company, had gone well. And this despite the fact that companies are very different, as are their prospects.

Gregan-Paxton and Cote(2000)[ii] studied how investors predicted the results for a target company selling its products on the Internet from the performance and characteristics of three other companies. They used 259 members of investment clubs which were divided into two groups; one had to predict the performance of the target company without an obviously similar company in the database; the other group had a comparable company, at least in its superficial characteristics, in the database. They compiled the predictions according to the arguments that the subjects made in explaining their analysis. They were thus able to divide the subjects into those who from the examples were able to imagine the keys to success on the Internet and those who were not able to discover the obvious principle. It emerged that subjects who were not able to uncover the principle at work on the Internet had employed a shallow reasoning by analogy process and then predicted that the performance would be comparable to that of the company which was superficially the most similar to the target company. Those who had found the operative principle had, moreover, applied the rule in responding, using a structural analogical reasoning. In a less intuitive way, it came out as well that among the individuals who had discerned the principle, fewer used that principle, which they had understood, to arrive at their answers when the database included a company superficially similar to the target company than when it did not include such a company. These results tend to show that, on the one hand, analogical reasoning serves as a strategy of second choice when there is nothing else to use in order to make a decision and, on the other hand, that in the presence of a similar company, certain individuals willingly ignore the rules that they have understood and place them on a lower level when arriving at their predictions.

Conclusion

Starting from an example to find the general principle is a perilous undertaking. Even if it is easier, reasoning by analogy does not give as good a result as reasoning by logic. Having examples in mind of noteworthy facts concerning the performance of investments can engender ideas for investing. However, one must follow up and go more deeply into these ideas to learn whether the example which stimulated the idea was representative or only anecdotal.

Source: 50 psychological experiments for investors, Mickaël Mangot, Wiley (2009)


[i] Tversky, A., and D. Kahneman, “Availability: A Heuristic for Judging Frequency and Probability,” Cognitive Psychology, 5, (1973): 207-232; Tversky, A., and D. Kahneman,  “Judgment under Uncertainty: Heuristics and Biases,” Science, 183, (1974): 1124-1131.

[ii] Gregan-Paxton, J., and J. Cote, “How do Investors Make Predictions? Insights from Analogical Reasoning Research,” Journal of Behavioural Decision Making, 13, (2000): 307-327.