- Biases, argues Hannes Viljoen, are deadly in investment decision-making – yet many of us have them.
- The first of seven common biases is recency or availability bias, which refers to the brain's tendency to recall and place a heavier weight on information recently acquired.
- Like all biases, it could be costing you.
- But there's a way to overcome those biases - and in this seven-part series, he explains how.
Recency bias refers to the brain's default of recalling and placing a heavier weight on information recently acquired. The cognitive error made in decision-making is extrapolating recent events into the future or placing a disproportionally high weight on the relevance of the information.
During bear markets, investors tend to forget about bull markets. The recent crisis led to a big, sudden drop in the share market and consequently a big influx into money market and income funds or into cash, at a time when rates have fallen by 3.00% so far this year and could quite possibly fall further.
The story goes both ways. In a bull market, investors tend to forget about the bear markets. The NASDAQ, the US Index that has a high weighting to technology stocks, is up 19.8% for the year as at the end of July.
Extrapolation of recent events, far into the future; extrapolation of recent earnings, far into the future.
The pendulum of psychology in markets regularly swings from fearlessness to hopelessness.
Here is where the concept of base rates and regression to the mean is so important.
A base rate is loosely explained as the rate of past occurrences.
As an example, the average annual return for the S&P 500 (one benchmark of the American stock market performance), since inception, has been around 10%. If you are constructing expectations around future returns of the S&P, your starting point should be 10%. From there you will adjust the expectation upwards or downwards.
When an analyst forecasts that the S&P will deliver annualised returns over the next ten years of 15%, you have to ask yourself: what is the probability of this actually happening, given that the base rate is only 10%?
This is not to say the analyst is wrong, but you have to investigate and justify why this is your expectation, given the historical base rate.
Here is where the concept of regression to the mean is so important.
If markets are down, for example, 10% over the past year; and the base rate for markets are to return 10% over the long term, the probability that the market will deliver the base rate return over the next year, or a return in line with the base rate, has increased. It is not a given; however, the probability has increased. Returns will over time revert to the mean (except if there has been a fundamental change).
But people have the tendency to extrapolate the recent past.
Howard Markets wrote in a memo titled ‘On the couch’ in January 2016:
We tend to look at what has happened over the recent past, especially if it was a particularly bad period, and extrapolate it into the future. We tend to start using words and phrases such as ‘never’, ‘forever’, ‘absolutely’ and ‘there is no doubt’.
Ian Wilson, former chairman of General Electric, once said:
Breaking the cycle
How do we hedge ourselves to falling prey to recency bias?
Knowing about it is a good place to start, but not enough. There are two ways you can try to avoid this bias, one general way of dealing with all biases and decisions and one specific.
A general way to hedge against biases is to have a group of people that you can share ideas with. Annie Duke defines this group as a ‘truth-seeking group’ in her best-selling and highly recommended book Thinking in Bets: Making Smarter Decisions When you Don’t Have All the Facts. The aim of the conversation in the group should be to discuss hypotheses in an environment with the aim to get to the truth of a matter and not necessarily to be right.
Another way you can go about thinking more clearly about an investment decision, is to picture the following image:
Imagine you are standing on top of a mountain, everything is calm and stable, you make decisions with a clear mind, and you gaze far ahead of you to the horizon. When uncertainty arises, especially rapid uncertain events, you drop your gaze. First to a few hundred meters in front of you, then ten, and when uncertainty is at its highest, you are hesitant about the future and you look at your feet.
The error you need to be cognizant of is not to make investment decisions now by looking at your feet. At this point, you are making decisions based on a recently available reference point and not the big picture. You should always make a decision by picking up your head and looking at the horizon. Granted, your decision-making horizon could be short, but for the majority of investment decisions, the horizon is some distance away.
This is applicable to important decisions in life, not only investing. Slow down the decision-making process. Lift up your head and look into the horizon. Consider the base rate. Do not make high impact investment decisions on your own. Understand; really understand the concept of regression to the mean.
Hannes Viljoen is a Chartered Financial Analyst. Views expressed are his own.
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