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Q4 2016
Behavior Finance: The Three As – Availability, Anchoring & Adjustment

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Pioneering behavioral finance researchers Kahneman and Tversky (K&T) describe availability as the impulse to, "assess the frequency of a class or the probability of an event by the ease with which instances or occurrences can be brought to mind."

Pioneering behavioral finance researchers Kahneman and Tversky (K&T) describe availability as the impulse to, "assess the frequency of a class or the probability of an event by the ease with which instances or occurrences can be brought to mind."

For example, which of the following causes more fatalities in the United States in a year?

a) shark attacks, or
b) airplane parts falling from the sky


c) homicide and car accidents, or
d) diabetes and stomach cancer

If you guessed a) and c)—sharks and homicide or car accidents—you are in the majority, but you are also wrong.

Airplane parts falling from the sky are thirty times more likely to cause death in the U.S. than shark attacks, and diabetes and stomach cancer are twice as likely as homicide and car accidents. It is the ease by which we recall shark attacks and homicides or car accidents from news reports or sightings in our neighborhood that causes us to think otherwise.

The following paragraph contains references to publically traded companies. We selected these companies to illustrate the behavioral finance characteristics discussed in this paper and because they’re familiar to many investors. These references are for ILLUSTRATIVE PURPOSES ONLY. The references are NOT RECOMMENDATIONS to transact in any securities issued by these companies, and we do not represent that these securities were recommended to our advisory clients.

For a hypothetical investing example of availability, consider this question: Most great advances in the commercialization of information technology have occurred in the last two decades. If we ignore dividends, which company’s stock provided the greatest price appreciation over the last twenty years?

a) Kansas City Southern, a railroad company, or
b) Microsoft, which provides the operating system for countless personal computers and servers

By ignoring dividends, we leveled the playing field for Microsoft because it only began paying dividends in 2009. Microsoft’s stock price appreciated an astounding 1,193% during the 20-year period from August 1, 1994 through July 31, 2014. Meanwhile, Kansas City Southern appreciated 13,775%; more than 11 times as much as Microsoft.

Perhaps many guessed in favor of Microsoft because it is considered one of the greatest growth businesses of all time, or because founder Bill Gates is one of the world’s richest men.

How many people can recall the last time they bought an item that had spent time on a Kansas City Southern railcar? The availability heuristic can cause us to miss great opportunities if we fail to uncover those that do not come to mind easily.

As with representativeness, we must actively apply slow thinking processes and seek information that requires the employment of System 2, which allocates attention to higher-level mental activities such as complex computations, rather than System 1, which relies on rules-of-thumb or shortcuts.

Using information technology, we can scan entire data sets for evidence of opportunities with which we are not familiar. Often the best investment ideas are those that investors dislike or do not know exist.

Anchoring and Adjustment

"In many situations, people make estimates by starting from an initial value and adjusting to yield a final answer." K&T wrote that an issue arises because those adjustments "are typically insufficient. That is, different starting points yield different estimates, which are biased toward the initial values. We call this phenomenon anchoring."

For example, the financial results of most companies rise and fall over time, affecting their business valuations. Yet, investors often reference a particular value estimate, even when new evidence suggests the original estimate is no longer accurate.

Researchers have identified anchoring as a factor in the limited impact of good news on stocks near their 52-week high prices. Investors often anchor on and sell near the high price without sufficiently adjusting for positive news, which allows momentum investors to achieve statistically significant outperformance as buyers when a stock’s momentum rises near its 52-week high.

Fundamental investors value businesses using several methods, often with ratios that compare price to other objective fundamental measures for apples-to-apples comparisons between different companies.

A focus on ratios rather than current prices helps investors adjust properly and minimizes the effects of this bias.


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