As investors, and humans, we can’t help it. We have a tendency to succumb to behavioral biases such as “recency,” which lulls us into the trap of assuming that, because something happened yesterday/last month/last year, it will repeat indefinitely into the future.
We are particularly prone to recency bias during bad times in the market. (Get me out! The world is ending!!) During the 2008 market crash, investors pulled out record amounts of cash from the stock market and into presumably safer harbors such as bonds – just before the stock market went on to experience double-digit returns over the next couple of years. Similarly, with the market rise in late 2013, billions of dollars poured in, seeking to chase recent market highs.
The tendency to chase returns up or down goes to show how we can be powerfully influenced to make rash investment decisions based on recent noise rather than the scientific evidence on how to capture long-term market growth. It’s not that bad returns don’t happen over time, it’s just that trying to predict when and where they will occur is a foolish pursuit. Instead, you’re best served by building a well-designed, low-cost portfolio, and then sticking with it over time. That way, you can most efficiently capture expected premiums as they become available, and stay disciplined when the related risks happen.
To help put all this into context, here are additional thoughts about recency bias from our BAM ALLIANCE Director of Investor Education Carl Richards.
Beware of Recency Bias
In a standard winter, Long Island uses about 30,000 tons of salt to keep its roads clear of ice. As of now, it’s already used 46,000 tons, and Phil the groundhog predicted we’ll face six more weeks of winter. They’re definitely going to need more of the stuff before winter ends. But Long Island and other communities hit hard by winter have a problem. There’s a salt shortage.
It may sound odd because most of us have a canister of salt sitting in a cupboard. How can there be a shortage of salt?
Transportation departments use a specific kind of salt, road salt, to de-ice roads. Each year, these departments contract for a certain amount of salt to be readily available. Contracts often include an option for an additional 20 percent at the contract price. After that, they have to pay the market rate, and if there’s a regional shortage like the one on Long Island and in New Jersey, supplies may need to be trucked in from other areas, adding to the cost.
It might be tempting to say that based on this year, transportation managers should contract for more than 30,000 tons of salt for Long Island next winter. But that’s a reaction based on what we’ve just experienced as opposed to putting this year in context with previous winters. It’s a classic example of our tendency to show a recency bias.
Because we’re human, we’re inclined to take the thing we just experienced and project it into the future. It becomes our point of reference, and tricks us into thinking and feeling a certain way about different things.
Up until a few weeks ago, it was easy to think the market would only keep going up. But news started popping up about emerging markets, China and who knows what else, and the daily market reports started showing negative returns. Out of curiosity, how are you feeling about the markets now? I suspect it’s not as easy to think and feel as positively about the markets now as it was in December.
However, it’s incredibly easy to lose our perspective when we’re bombarded with so much of what we’re told is incredibly important and relevant information. We’d be fools to ignore the signs of a market correction or China coming in for a hard landing, right?
Here’s the thing: We have ZERO control over most of this stuff happening. Yet, we allow it to trigger behavior that isn’t in our best interest.
If the transportation manager decides he needs to order at least 46,000 tons of road salt for Long Island going forward, odds are high that he’ll end up with a lot of extra salt in many years. As a result of that additional cost, it may mean fewer road repairs and rougher roads the rest of the year.
The same holds true for our decisions. If we let what’s just happened become the sole reason for certain decisions, we may end up limiting our options in the long-term. And it’s not only an issue around money decisions. We’ve got to be smarter than our lizard brains and push back against the instinct to assume that forever will always look like now—at least until something happens and we change our minds again.
Copyright © 2014 Behavior Gap, All rights reserved
Carl Richards is the author of, “The Behavior Gap” which is an excellent book that illustrates how we human beings are prone to exercise bad behavior when making decisions about investing and about life. Carl drives his points home in plain, common sense, language and clever illustrations making The Behavior Gap a great resource for people from all walks of life to improve their lives and their relationships with money.