Wednesday, 7 September 2016

Lessons from Charlie Munger-XIII

Oct 5, 2012

In the previous article, we discussed the contrast misreaction tendency and elaborated how it has an adverse effect on investments. Today we shall discuss yet another erroneous psychological tendency that causes investors to misinterpret information, resulting in wrong investing decisions.

Availability-misweighing tendency

The first thing many people do after they wake up in the morning is grab the newspaper. Reading the paper gives us a sense of what's going around in the real world. The same is true for television news channels. Based on what is served to us by the news media, we build our mental model of what the real world outside is like.

But does this mean that the news stories presented by the media are the most important and legitimate issues concerning us? What about issues that don't make it to the newspaper or the TV but still could be very relevant and vital? This discrepancy often leads us into a distorted view of reality. What appears more often and more prominently around us assumes a lot more importance than it may deserve. On the other hand, issues that may not be discussed could be disregarded as trivial. 

This brings us to availability-misweighing tendency. What does it mean? Charlie Munger explains it very aptly quoting a song: "When I'm not near the girl I love, I love the girl I'm near." The human mind has a tendency to focus on what's easily available. And in doing so, often tends to give undue importance to it. On the other hand, the significance of things and events that are not easily accessible could be undermined.

Availability-misweighing tendency in the stock markets

Business fundamentals and earnings drive stock prices over the long term. However, on a day-to-day basis, it is the relentless flow of news and information that sends markets up and down. Owing to this intricate relationship with news, the stock market is one place that most easily falls prey to the availability-misweighing tendency. Isn't it often observed that news items that are prominently projected in the media elicit substantial response from the stock markets? In other words, the markets are ready to react to any information that is made available to them. This also means that important matters that are not covered by the news media may be ignored by the stock markets. 
Take for instance, the recent slew of economic reforms announced by the government. The initiative has been covered extensively by the media. Though most of these reforms are not very significant and are unlikely to have any major positive impact on India's economic growth in the near future, the sentiment on the Indian bourses has suddenly turned optimistic.

The case of individual investors is also very similar. Stocks that are most widely talked about in the media often make an easy entry into the stock portfolio. Many companies tend to use this tendency to prop up their share prices. Using their PR machinery, companies bombard the media with press releases, interviews and news reports about every trivial development and achievement, many of which may not have any major impact on earnings. But in the absence of other relevant information, investors often end up giving undue importance to such insignificant matters. 

In the next article, we will discuss what investors can do to avoid falling prey to this think error.

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