How to counter Availability Cascade in markets

The equity markets react to news and each perceived risk associated with that news/ information gets discounted. Most times, this discounting is done with an extreme extrapolation of the possibilities leading to distorted outcomes. This is nothing but the collective assumptions of the market participants and their views about the outcome. It’s only as the information gets more qualified; would the discounting factor adjust to reality.

Take the case with Liberation Day tariff announcements last year or the ongoing Iran conflict. In between we’d the perils of overinvestments by the hyperscalers on the AI infrastructure and then the AIpocalyse of software industry. While the narratives form at both extremes, the reality usually sits somewhere in between. Certainly, the AI’s influence on software industry is for real but does that mean the entire SAS (Software-As-Service) model is redundant and most critically the timelines assumed for upending on this.

Similarly, as the war escalates and extends, every new information on the damage to the existing infrastructure, the flows at the choke points and the supply constraints on oil cast clouds on the prospects of economic growth. It becomes difficult to arrive at a price that resembles the risk. As investors turn their focus on the emerging events, the pricing of the risk becomes difficult resulting in higher volatility.

One of our biggest traits as a human are the risk assessment by their availability i.e., to verify the risk based on the intensity and probability and importantly on how emotive it is. The fight-flight reaction to risk is an evolutionary instinct that allowed us to prosper but in investment it could hazard an impediment to progress and most probable reason for mispricing. This is because, as I mentioned earlier, our tendency to extrapolate and even exaggerate the current situation leads to incorrect assessment. Of course, in most cases, we’re not sure of what the future holds.

New risks emerge for each of these new geopolitical events that tend to become vibrant in our awareness leading us to time the market – either sell or buy. And each new risk becomes prominent in our minds while the earlier risks are either ignored or neglected. So, if we act on a risk-off mode at every event, then how could one make money in the markets. But, in investing we find a train of risks one after the other and how to trade them?

This ‘availability cascade’, a psychological and social phenomenon where an idea often emotionally charged spreads rapidly and becomes widely accepted. Legal scholars Timur Kuran and Cass Sunstein in their 1999 paper “Availability Cascades and Risk Regulation” developed this concept. They used it to explain how public risk perception often diverges wildly from actual statistical risk.

Availability cascade is a self-reinforcing process in which a shared fear or idea gains increasing plausibility simply through its repeated exposure in public discourse not because of its objective truth or importance but because it spreads rapidly through a population making it feel increasingly credible the more people talk about it. Availability isn’t usually about imaginary risks but overstating the risks as we become aware of. So, the closure of strait has always been an existing risk, but it was never priced in till the recent escalations. The bubbles or panics in markets is an illustration of this availability cascade. Our reliance on heuristics (mental shortcuts) and emotional stories (over statistical proof) effects in greed and fear amongst us. Especially, fear and uncertainty accelerate speed, and we see markets crashing in panic. For investors, it’s important to tune out the noise and concentrate on those factors that are in their control. Trying to price-in every aspect of the external changes is not just difficult but counterproductive.

Breaking the cascade requires transparent data, slow deliberation, rational action and resistance to alarmist repetition. Higher damage is caused by our reaction to the market than the market actions. It’s, thus, important to assess self before investing in equity. What percentage of losses could be absorbed and so the proportion of allocation to equities. As risk tolerance is established, the objectives are defined with timelines and goals demarcated - the portfolio stands the test of time and YOUR patience. Market gyrations is a feature and staying invested is the only rule that allows you to compound.

(The author is a partner with “Wealocity Analytics”, a SEBI registered Research Analyst and could be reached at [email protected])