Tag Archives: Recency Bias

The 5-Mental Traps Investors Are Falling Into Right Now

I recently wrote about the “F.I.R.E.” movement and how it is a byproduct of late-stage bull market cycle. It isn’t just the “can’t lose” ideas which are symptomatic of bullish cycles, but also the actual activities of investors as well. Not surprisingly, the deviation of growth over value has become one of the largest in history.

This divergence of the “performance chase” should be a reminder of Benjamin Graham’s immortal warning:

“The investor’s chief problem, and even his worst enemy, is likely to be himself.” 

With valuations elevated, prices at record highs, and the current bull market the longest in U.S. history, it seems like a good time to review the 5-most dangerous psychological biases of investing.

The 5-Most Dangerous Biases

Every year Dalbar releases their annual “Quantitative Analysis of Investor Behavior” study which continues to show just how poorly investors perform relative to market benchmarks over time. More importantly, they discuss many of the reasons for that underperformance which are all directly attributable to your brain. 

From Dalbar’s 2018 study:

“In 2018 the average investor underperformed the S&P 500 in both good times and bad, lagging behind the S&P by more than 100 basis points in two different months.”

Cognitive biases are a curse to portfolio management as they impair our ability to remain emotionally disconnected from our money. As history all too clearly shows, investors always do the “opposite” of what they should when it comes to investing their own money.

Here are the top-5 of the most insidious biases investors are falling into RIGHT NOW!

1) Confirmation Bias

As individuals, we tend to seek out information that conforms to our current beliefs. If one believes that the stock market is going to rise, they tend only to seek out news and information that supports that position. This confirmation bias is a primary driver of the psychological investing cycle of individuals as shown below. I discussed this just recently in why “Media Headlines Will Lead You To Ruin.”

As individuals, we want “affirmation” our current thought processes are correct. As human beings, we hate to be told we are wrong, so we tend to seek out sources which tell us we are “right.”

Currently, individual investors are “fully” back in the market despite a fairly decent bruising in 2018. Historically, this has not turned out well for individuals, but given that “optimism sells,” it is not surprising to see the majority of the mainstream meeting touting a continuation of the bull market.

This is why it is always important to consider both sides of every debate equally and analyze the data accordingly. Being right and making money are not mutually exclusive.

2) Gambler’s Fallacy

The “Gambler’s Fallacy” is one of the bigger issues faced by individuals when investing. As emotionally driven human beings, we tend to put a tremendous amount of weight on previous events believing that future outcomes will somehow be the same.

The bias is clearly addressed at the bottom of every piece of financial literature.

“Past performance is no guarantee of future results.”

However, despite that statement being plastered everywhere in the financial universe, individuals consistently dismiss the warning and focus on past returns expecting similar results in the future.

This is one of the key issues that affect an investor’s long-term returns. Performance chasing has a high propensity to fail, continually causing investors to jump from one late cycle strategy to the next. This is shown in the periodic table of returns below. “Hot hands” only tend to last on average 2-3 years before going “cold.” 

I traced out the returns of large capitalization stocks (S&P 500) and U.S. Fixed Income (Barclay’s Aggregate Bond Index) for illustrative purposes. Importantly, you should notice that whatever is at the top of the list in some years tends to fall to the bottom in subsequent years. “Performance chasing” is a major detraction from investor’s long-term investment returns.

So, what’s hot in 2019, we detail this each week for our RIAPRO subscribers (30-day FREE TRIAL)

Currently, money is chasing Technology, Discretionary, and Communications, with Energy, Healthcare, and Bonds lagging. From a contrarian viewpoint, with “Value” dramatically underperforming “Growth” at this juncture of the investment cycle, there may be a generational opportunity soon approaching.

3) Probability Neglect

When it comes to “risk-taking” there are two ways to assess the potential outcome. There are “possibilities” and “probabilities.” As individuals, we tend to lean toward what is possible such as playing the “lottery.” 

The statistical probabilities of winning the lottery are astronomical. In fact, you are more likely to die on the way to purchase the ticket than actually winning the lottery. However, it is the “possibility” of instant wealth that makes the lottery such a successful “tax on poor people.”

As humans, we tend to neglect the “probabilities,” or rather the statistical measures of “risk,” undertaken with any given investment, in exchange for the “possibility” of gaining wealth. Our bias is to “chase” stocks, or markets, which already have large gains as it is “possible” they could move higher. However, the “probability” is that a corrective action will likely occur first.

With markets currently well deviated above long-term historical means, and valuations elevated, the possibility is greatly outweighed by the probability of a mean-reverting event first.  The following chart is derived from Dr. Robert Shiller’s inflation-adjusted price data and is plotted on a QUARTERLY basis. From that quarterly data is calculated:

  • The 12-period (3-year) Relative Strength Index (RSI),
  • Bollinger Bands (2 and 3 standard deviations of the 3-year average),
  • CAPE Ratio, and;
  • The percentage deviation above and below the 3-year moving average. 
  • The vertical RED lines denote points where all measures have aligned

Over the next several weeks, or even months, the markets could certainly extend the current deviations from long-term mean even further drive by the psychology of the “herd.” But such is the nature of every bull market peak, and bubble, throughout history as the seeming impervious advance lures the last of the stock market “holdouts” back into the markets.

Probability neglect is another major component to why investors consistently “buy high and sell low.”

4) Herd Bias

Though we are often unconscious of the action, humans tend to “go with the crowd.” Much of this behavior relates back to “confirmation” of our decisions, but also the need for acceptance. The thought process is rooted in the belief that if “everyone else” is doing something, then if I want to be accepted, I need to do it too.

“If all your friends jump off a cliff, are you going to do it too?” – said by every Mother in history.

In life, “conforming” to the norm is socially accepted and in many ways expected. However, in the financial markets the “herding” behavior is what drives market excesses during advances and declines.

As noted above, the “momentum chase” currently is good example of “herding” behavior. As Michael Lebowitz noted recently:

“The graph below charts ten year annualized total returns (dividends included) for value stocks versus growth stocks. The most recent data indicates value stocks have underperformed growth stocks by 2.86% on average in each of the last ten years.”

“There have only been eight ten-year periods over the last 90 years (total of 90 ten-year periods) when value stocks underperformed growth stocks. Two of these occurred during the Great Depression and one spanned the 1990s leading into the Tech bust of 2001. The other five are recent, representing the years 2014 through 2018.

When the cycle turns, we have little doubt the value-growth relationship will revert. In such a case value would outperform growth by nearly 30% in just two years. Anything beyond the average would increase the outperformance even more.”

Moving against the “herd” is where investors have generated the most profits over the long term. The difficulty for most individuals, unfortunately, is knowing when to “bet” against the stampede.

5) Recency Bias

Recency bias occurs when people more prominently recall, and extrapolate, recent events and believe that the same will continue indefinitely into the future. This phenomenon frequently occurs in with investing. Humans have short memories in general, but memories are especially short when it comes to investing cycles.

As Morningstar once penned:

“During a bull market, people tend to forget about bear markets. As far as human recent memory is concerned, the market should keep going up since it has been going up recently. Investors therefore keep buying stocks, feeling good about their prospects. Investors thereby increase risk taking and may not think about diversification or portfolio management prudence. Then a bear market hits, and rather than be prepared for it with shock absorbers in their portfolios, investors instead suffer a massive drop in their net worths and may sell out of stocks when the market is low. Selling low is, of course, not a good long-term investing strategy.”

This bias in action looks a lot like the chart below.

During bull markets, investors believe that markets can only go up – so “buy the dip” becomes a “can’t lose” investment strategy.  This bias also works in reverse during bear markets. Investors become convinced the market will only go lower which eventually leads them to “panic selling” the lows.

Recency bias is the primary driver behind the “Buy High/Sell Low” syndrome.

Everyone’s A Genius

The last point brings me to something Michael Sincere once penned:

“At market tops, it is common to see what I call the ‘high-five effect’ — that is, investors giving high-fives to each other because they are making so much paper money. It is happening now. I am also suspicious when amateurs come out of the woodwork to insult other investors.”

Michael’s point is very apropos, particularly today, it’s currently “high-fives and pats on the back.” 

The market’s ability to seemingly recover from every setback, and to ignore fundamental issues, has led investors to feel “bulletproof” as investment success breeds overconfidence.

The reality is that strongly rising asset prices, particularly when driven by emotional exuberance, “hides” investment mistakes in the short term. Poor, or deteriorating, fundamentals, excessive valuations, and/or rising credit risk is often ignored as prices increase. Unfortunately, it is only after the damage is done the realization of those “risks” occurs.

For investors, it is crucially important to understand that markets run in full cycles (up and down). While the bullish “up” cycle lasts twice as long as the bearish “down” cycle, the majority of the previous gains are repeatedly destroyed.

The damage to investors is not a result of lagging markets as they rise, but in capturing the inevitable reversion. This is something I discussed in “Bulls And Bears Are Both Broken Clocks:”

“In the end, it does not matter IF you are ‘bullish’ or ‘bearish.’  The reality is that both ‘bulls’ and ‘bears’ are owned by the ‘broken clock’ syndrome during the full-market cycle. However, what is grossly important in achieving long-term investment success is not necessarily being ‘right’ during the first half of the cycle, but by not being ‘wrong’ during the second half.

We are only human, and despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases which inevitably leads to poor decision making over time. This is why all great investors have strict investment disciplines they follow to reduce the impact of their emotions.

At market peaks – everyone’s a “Genius.”Save

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Lessons From Thanksgiving Dinner

Talking to friends and family at Thanksgiving dinner made me realize how unprepared for volatility investors are. The gathering I attended was filled with a wide mix of investors, from the young and novice interested in technology stocks and (somehow still) in Bitcoin to older, seasoned veterans. The veterans, however, didn’t exhibit much more savvy than the novices; everyone was spooked by the recent volatility.

Based on my Thanksgiving Dinner experience, here’s what I think investors need to learn now.

Re-Set Your Expectations

First, I think investors are spooked because they are being unduly influenced by the market action of 2017. But that was an unusually calm year that saw a 22% gain in the S&P 500 without a down month. That’s a Bernie Madoff-like performance — straight up every month like clockwork with no hiccup to the downside. That kind of performance usually only occurs when someone makes it up. Investors should realize that 2017 is an anomaly and that volatility is part of investing. Financial markets are rarely that smooth and stable. Do your best to expunge 2017 from your memory.

Below is a monthly chart of how the S&P 500 Index performed in 2017 and for the first 10 months of 2018. It may surprise you to see that the index was still in positive territory at the end of October. A $100 investment in the index at the start of the year was still worth more than $102 on Halloween. As of this writing (Nov. 23), the index was still in positive territory, albeit barely ((0.19% for the year, including dividends).

I don’t point out that the market is still positive to give investors encouragement to take more risk though, or to argue that markets have delivered solid returns this year. I do so in order to impress on you that large cap U.S. stocks are still positive, and that your sense of markets might be warped. This year feels awful to investors, but the returns really haven’t been bad. There’s a disconnect between the year’s returns and what the year has felt like. That’s because 2017 was so strange in the index posting positive gains for every month.

Reconsider Your Allocation

I also don’t mean to encourage investors to think they can time markets perfectly. The point is not to dance in and out of stocks adroitly, missing losses and capturing gains; it’s having an allocation that gives you enough of the upside and allows you to live with the downside without shaking you out of your investments. If the recent volatility makes you want to sell, chances are you have too much stock exposure, or you have to re-calibrate your expectations from financial markets.

I think most investors I meet with have more stock exposure than they can handle. Or at least they strike me as being badly prepared for declines either because they don’t have advisors or because they have incompetent advisors who don’t disclose risks and historical volatility. When declines come, many of them will bail out at or near the bottom despite the fact that Morningstar’s most recent “investor return” numbers suggest investors are getting better at mistiming markets. Instead of falling into that trap you should reassess your allocation now, before any damage has occurred. That’s not a prediction that a crushing decline is around the corner; I wish I could be that clairvoyant. But you should always be prepared for one. And you should have an allocation that encourages you to buy after a big market decline, not sell.

Hold Extra Cash, But Avoid Bunker Mode

Having just given all those warnings about market timing, I still think it’s fine to hold some extra cash. Every reasonable market valuation metric, including the Shiller PE and Tobin’s Q, is flashing expensive. None of these indicators are good at forecasting short term market moves; markets can get (and have been) more expensive. But they are good are forecasting the next decade’s worth of returns. Returns will likely be low from current valuations. That means holding some extra cash is warranted. But, for goodness sake, don’t go to 100% cash with long term assets, thinking you’ll time your reentry perfectly. The paradox of sidestepping a decline is that if the market crashes, there’s a good chance that you’ll feel so good for having missed the decline that you’ll have a lot of trouble getting back in. But 10% or even 20% more cash or shorter term U.S. Treasuries than usual for long term assets isn’t unreasonable either.

Don’t Be A Victim of Recency Bias

Is it possible that stocks aren’t overpriced? Financial adviser Josh Brown raises the possibility, arguing that earnings can grow into their prices. After all, Amazon, Netflix, and Nvidia have seemed overpriced to investors for a long time, but their economic performance keeps improving. As Brown puts it, with all of these stocks in the recent past, “[t]he fundamental stories grew up to justify the valuations investors had already been paying (Brown’s emphasis).”

And this can also happen to entire markets. Five years ago, the market’s cyclically adjusted P/E ratio (CAPE or Shiller PE) was higher than it had been in 87% of all readings up until that point. But the stock market has been up 90% since then. “No one could have known that the fundamentals would arrive to back up the elevated valuations for stocks eventually,” according to Brown.

This last statement is odd. In May of 2013, the S&P 500 carried a CAPE of 23. Now its CAPE is 31. It’s not clear from this simple valuation metric that stock earnings have grown into their new, elevated prices. Past ten-years’ worth of earnings ending in 2013 were $78, according to Robert Shiller’s data. For the most recent ten-year period, they are $84. Ironically, one could make the argument that earnings have grown into the 2013 price five years later, but not the 2018 price. It we apply the May 2013 price to the past decade’s worth of earnings ending today, we get a CAPE of around 21. That’s much more reasonable than the current one of 31.

In fact, if we agree that the long-term historical average CAPE of nearly 17 is outdated, and that the new average should be around 20 or 22, then the 2013 price of the market relative to the past decade’s worth of earnings ending today is roughly the correct valuation. That also means all the price advances the market has made since 2013 do not reflect underlying economic reality or earnings power value of the market. In other words, earnings have increased, but stock prices have increased much more so that the market should be trading at 2013 prices given the past decade’s worth of earnings.

Brown’s point, of course, is that the earnings growth of the past decade can repeat over the following decade. But that also means that for stocks to deliver robust returns, the current 31 CAPE valuation must reappear 10 years from now. That’s possible, but investors and advisers must contemplate how they would like to bet and what they must tell clients if they are behaving as fiduciaries.

It’s possible that we could wake up to a 31 CAPE in a decade, and that U.S. stocks will have delivered 7% or so nominal returns (2% dividend yield plus 4%-5% EPS growth). It’s also possible that earnings-per-share can increase at a greater clip than they have historically. Nobody should say those things are simply impossible. But if you are managing your own money, or advising others in a fiduciary capacity (which means you must treat their money with all the care you do your own), how reasonable is it to expect that as what forecasters might call a “base case?” At best, assuming we’ll all wake up to a 31 CAPE in a decade must be a very rosy, low-probability scenario.

There’s an irony to Brown warning against those who carry on about backward looking valuation metrics. One of the most well-known observations of behavioral finance is that human beings can be seduced by recent patterns, including recent securities price movements. We tend to assume, without any evidence other than the recent pattern, that price trends will continue. Everyone will have to decide for themselves whether deriving encouragement from a 90% stock price move without a commensurate earnings increase, as Brown does, reflects proper attention to simple arithmetic or our susceptibility to extrapolate recent stock price movements and returns into the future.