Do you think a blizzard will drive up the demand for people wanting to buy snow tires or 4-wheel drive vehicles? Sure does.
How about car dealerships – will they sell more convertibles once the weather gets warmer? Without a doubt.
What is at play here is a psychological phenomenon called recency bias. It is the tendency to believe that something is likely to happen again because it occurred in the recent past. It’s why we buy umbrellas after a week’s worth of rain or a generator after a long power outage.
The inverse also applies – the longer the amount of time since an event took place, the less likely people think it will happen anytime soon.
As it pertains to investing, it can cause you to make bad investment buy-sell decisions. Naturally, people will want to own investments that have done well recently. Sometimes they buy stocks which have already appreciated substantially because they believe the stock will just continue to go up.
THIS JUST IN: Recency bias may skew your perceptions toward short-term thinking.
Recency bias works the same in down markets. A great example of this occurred in 2008: stocks steadily fell and investors sold losing positions and went into cash. Many of these people locked in losses that ended up being at, or near, the bottom. Convinced that declines could continue, far too many sat un-invested over the next couple years as the bull market was well underway.
These are classic cases of recency bias, and it tends to be exacerbated during periods of large market moves. What’s occurred so far in 2020 is no exception. Here are the worst market months in nearly 100 years of capturing the data:
We just had one of the worst months of market declines in decades (March 2020 in yellow). Most of us know that March of this year was painful, and our account balances dropped. Not surprisingly, studies showed that people made substantial moves to invest into…<gulp>… CASH!
Maintaining a long-term view is one of the best defenses when this occurs. If your asset allocation accurately reflects your goals and tolerance for risk, then it should be easier to look past the recent market declines.
Granted, it’s not easy to do. And I had some conversations with people who panicked over the Covid-19 market declines. They wanted to sell.
I tried to remind investors that what matters is not what the market did in the last day, week, or month, but what it is likely to do in the future. And when I say “future”, that can be decades for some people.
If you are thinking “what if I don’t have a lot of years”, or if you have shorter-term goals? My response would be you shouldn’t have that money in the stock market in the first place.
So for those that were patient, and didn’t make any knee-jerk reactions? Take a look at what happened in April 2020.
Talk about a quick roller coaster ride (April 2020 is highlighted)! We just experienced one of the worst months in stock market history, followed by one of the best months. The last (and only) time the market was down double digits one month then up double digits the next was in 1974.
I recognize that being human, we are all prone to have biases that can lead us astray when making investing decisions. Besides taking a long term view, we should take comfort in knowing that over longer periods of time – markets have risen.
Market corrections (defined as a 10% drop in value) and bear markets (drops of 20%) have occurred several times over the years, and are going to happen again. Investors should EXPECT both bulls and bears to happen going forward.
No one knows when, of course. But we know what will happen after these periods – the market proceeds higher. There has never been a rolling 20 year period where the markets lost money.
That is why you must resist the temptation to react to current headlines or recent statements. Stay focused on your goals and let the markets do the rest.
What else can you do? Recruit a second set of eyes. It would be a good idea to seek an objective perspective from a family member, friend, or financial advisor. They may be able to access the situation and point out some blind spots.
The recent past may be fresh in our minds, but putting it in the proper context can help keep it from wreaking havoc on your investments. Don’t become a victim of recency bias – it could cause you to make wrong decisions at the wrong time.