Short Term Memories, Long Term Discipline
As if the stock market doesn’t already throw us enough curve balls and changeups, our own, all-too-human minds often trick us into swinging at air when it comes to making wise investment decisions. Behavioral finance, an entire field of academic inquiry, sheds light on why we investors do some of the crazy things we do, despite all logic.
Today, I want to focus on a behavioral trick known as RECENCY. Because recency is at its most dangerous during particularly volatile markets, I think it’s important to understand that: (1) you are probably subject to it, and (2) knowing this can help you avoid succumbing to it.
In his book, Your Money and Your Brain, Jason Zweig describes recency bias as, “the human tendency to estimate probabilities not on the basis of long-term experience but rather on a handful of the latest outcomes. … Whatever has happened most recently will largely determine what you think is most likely to happen next.”
Applying this bias to investing, it means that when the recent direction of the stock market has been downward, investors tend to assume that it will stay that way or get worse, onward into the future, with no hope in sight. Ugh. Recency plays the same trick on us in reverse when markets roar forward. In bull markets, investors like to convince themselves that the party will never end. No wonder our poor brains practically short-circuit during highly volatile markets!
Why does recency exist to begin with? Like other behavioral hardwiring, it was probably born out of necessity. Those who mastered it were most likely to survive in dangerous physical surroundings. If you’re in the depths of a prehistoric European winter, for example, it’s best to keep that fire well-stoked, assuming that the recent cold is likely to continue.
Even in our modern lives, recency can be handy in making many quick, correct decisions. For example, if you’ve just emerged from a rush-hour traffic jam into a patch of smooth sailing, I think we can all agree that it’s best to keep a particularly watchful eye for more bottlenecks up ahead.
Thus, these kinds of life lessons were ingrained in us deep along the way and remain valid in much of our daily lives today. However, recency has a way of turning on you when applied to your wealth. Particularly since you are a long-term investor, right?
Remember that chart I showed you in my May President’s Letter, in which all the asset classes squiggled around in the short-term, but kept going up overall? Consider that same ride, viewed closer up.
If you make investment decisions based on recency-induced fear during periods of market doom and gloom, you’re likely to miss out on what is nearly impossible to see except in big-picture hindsight: those unpredictable growth spurts that have resulted in long-term accumulated wealth. Recency may be helpful in Interstate traffic, but when it comes to investing, it can detour you from arriving at your financial destination.
Repeat after me: You are a long-term investor.