Why we mess up when it comes to our equity investments

Jul 17, 2022

Consider these scenarios.

A passenger is on a 10-day cruise. Over this duration, from the observation deck of her cruise ship, she spots six green boats and six blue boats. However, the green boats pass by more frequently toward the end of the cruise while the passing of blue boats were concentrated toward the beginning. Following the cruise, there is a high probability that she will state that the number of green boats was more than the number of blue boats.

Your sibling ordered in Chinese thrice this month but over two weeks at the start of the month. However, over the past week, he ordered in a salad thrice. If you asked him what he has been eating this month, he would instinctively say that he has been indulging in salads.

What’s common? The Recency Bias has surfaced.

When 9/11 was still fresh in people’s memories, more Americans avoided planes and preferred driving. Though, the latter is much more dangerous. The memory of the recent catastrophe made the fear of flying weigh more heavily than it rationally should have done. According to 2020 statistics presented by the National Safety Council in the United States, these were some of the odds of death: heart disease (1 in 6), cancer (1 in 7), motor vehicle crash (1 in 101). As for passenger on an airplane, there were “too few deaths in 2020 to calculate odds”.

Recency Bias is the tendency to remember and form an opinion on the most recently presented information. Simply put, we give more weight to recent events.

This tendency to extrapolate our recent experience into the future comes naturally to us. From the examples above it is clear that it is evident in all aspects of our life. Even investors are not excluded.

Unfortunately, when it comes to investing, this can have disastrous consequences. Because it skews our view of reality and the future. What happened yesterday, might not necessarily happen again today, let alone tomorrow.

During a bull market, people inadvertently 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. When a bear market descends, falling stock prices can lead to panic selling, because hey, the market “will keep falling and never recover”.

Legendary investor Bob Farrell referred to this in a recent interview and explained it so well. “The longer a trend persists, the more people look at the trend as permanent. That’s why investors buy the most stocks or bonds at the peak in prices, and the least at the troughs.”

How can we control its impact?

Recency Bias happens when we assume recent performance equals future performance. Despite the disclaimers, our minds naturally want to project from the past. Here’s how to ensure that your mind doesn’t play tricks on you.

  • Don’t fight it.

You should never fight such biases, but work on not succumbing to them. To do that, recognise that it exists and acknowledge. Don’t beat yourself up about it. Any investor can fall prey to it, irrespective of age, gender, nationality or race.

As Jason Zweig says in his book, Your Money and Your Brain, it is human tendency to estimate probabilities not on the basis of long-term experience but rather on a handful of the latest outcomes.

So once you realise that whatever has happened most recently will largely determine what you think is most likely to happen next, look for logical explanations. Why do you think the market will rise forever? Why do you think we will never get out of the bear market? Forcing yourself to answer these questions will keep you grounded.

  • Look at history.

If the bear market is giving you sleepless nights, look at hard facts. Gut-wrenching falls notwithstanding, it has been positive.

Markets grow as economies grow as corporate earnings grow. This trend has persisted through countless crises. Despite all upheavals, markets are still driven by the same fundamentals.

Remember reversion to mean, the basic law of “financial physics”. Markets return to the mean over time. What goes up must go down, and what goes up the most usually goes down the most. Price trends get overextended in one direction or another, but eventually return (revert) to their long-term average. In other words, extreme volatility is generally temporary.

Excesses in one direction will lead to an opposite excess in the other direction. Think of a pendulum. The further it swings to one side, the further it rebounds to the other side.

  • Tune out the noise.

This year, markets have been tossed back and forth by headlines around the Russia and Ukraine. This kind of news falls under the umbrella of geo-political risk, which carries dynamics distinct from the usual challenges when it comes to investing, such as economic and corporate news or valuations.

This is nothing new. The India-Pakistan stand-off brought both sides close to war (2001), 9/11 terrorist attacks on the Twin Towers in New York (2001), war in Iraq (2003), the U.S. bombed Syria (2017), the North Korean crisis (2017), the sharp deterioration in relations between U.S. and China (2020), and the India-China border tensions over the past few years.

Geo-political risk can refer to a wide range of issues (military conflict between nations, a coup or uprising, climate change, Brexit). But in all of them, it creates uncertainty and instils fear. With geo-political risks, the market's short-term direction can change in a flash based on the latest headline.

  • Don’t predict and gamble.

Investors may try to predict the outcome of a geopolitical issue and then guess the impact it will have on investment markets, and accordingly invest. You could lose ALL your money. This is a dangerous play.

  • Stick to your analysis.

An investor was recently bemoaning his “lack of luck” with the EKI Energy Services stock. The stock was listed in 2021 and opened at Rs 140. It began to go through the roof. He wanted a piece of the action so picked it up at a shockingly high price (it skyrocketed to an all-time high of Rs 12,599 in January 2022). It dipped to Rs 7,200 levels in June and as I write this, it is quoting at around Rs 1,950.

Huge money is not made by speculating and gambling away your savings. It is made by understanding the business, analysing its cash flows and studying the financials, by watching how the management raises and deploys capital, evaluating its fair price, and finally having the conviction to hold on during market upheavals.

(I advised a reader to "analyse rather than try to guess the unknowable" when he asked if a recession is around the corner and he should change his strategy. Read it here.)

If you stick to your investment thesis, you will not get swayed by price swings and latest performance numbers, however good or bad. Always stay grounded in fundamentals.

  • Cyclicality comes with the terrain.

Pay attention to the cyclical nature of asset class returns, securities or asset groups.  No investment or fund performs spectacularly year after year. Real estate goes through phases. A value fund will not do well when momentum stocks are ruling in the market. Every investment style will not always do well. There will be a downdraft. But, if you have invested based on a solid thesis, and it still holds, the downturn will be temporary.

  • Work with what is in your control.

Control your asset allocation. Stay diversified. Invest after taking into account your investment tenure and how an instrument fits into your portfolio. Set realistic expectations. Comprehend the risk you can take. Try to minimize taxes. Have a sound buying thesis.

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SV Prasad
Jul 24 2022 11:05 PM
Very true, it is very hard if not impossible not to get influenced by recency bias to some extent or the other, even global institutions like US FED were no exceptions to it. It is sufficient if we are conscious of it and hedge our positions towards the stable equilibrium. Past statistics and trends are fair means to bank upon for a direction call for medium to longer run, if we are in a dilemma, exceptions are really exceptions to this… but for some rare black swan or global scale event of large and lasting impact., which will also even out fairly if one has time on their side. Key point in this context above all is to have a fair, reasonable and tempered down return expectations from each asset class based on cyclicality and believe in adhering to a well-defined asset allocation plan all the times.
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