Were Facebook Investors Fooling Themselves? Psychologists Say Yes

Despite plenty of ominous signs leading up to Facebook’s initial public offering last month, legions of small-time investors walked eagerly toward their financial doom. Why? Psychologists think they have an answer.

Fairly obvious indicators that Facebook’s giant IPO might not be the bonanza originally expected included slowing revenue growth, lower-than-expected demand from institutional investors, a lagging mobile strategy and a valuation at a whopping 107 times earnings, more than every S&P 500 company except Amazon. To many experienced investors – both before and after the IPO – it’s no surprise the stock now hovers at about 25% below its offering price.

So why did so many average Joes ignore the warning signs and plunk down their hard-earned cash? Psychologists lay the blame on “availability bias.”

Availability Bias

The mental phenomenon is arguably a critical factor that explains why so many people failed to accurately judge the risks, explained Rebecca Waber, manager at growth and innovation consultancy Innosight, in a Harvard Business Review blog post. Basically, investors were driven not by their economic judgments, but by the leading role Facebook plays in communicating the dramatic, and more often mundane, happenings in their lives.

Availability bias, pioneered by psychologists Amos Tversky and Daniel Kahneman (The Framing of Decisions and the Psychology of Choice, PDF), refers to the importance people place on personal knowledge and experience in making decisions. As noted by Moneyball author Michael Lewis in Vanity Fair, “people often assess the probability of an event by asking whether relevant examples are cognitively “available” [i.e., can be easily remembered].”