Ok, it was another roller coaster day last Friday. And, here’s what’s interesting. About a week and half ago, I had someone tell me the market was high, so they shouldn’t make any changes.
And then last week, I had someone say: the market’s fallen, so we shouldn’t make any changes.
Well…. which is it? Too high or too low?
What we have here is something called ‘recency bias’. “Recency bias” is the phenomenon of a person most easily remembering something that has happened recently, compared to remembering something that may have occurred a while back.
Every day we rely on habit to get a lot of things done. We commute the same way to work every day, we eat at the same restaurants and we shop at the same stores.
We rely on habit to help us make things easier because few people want to reinvent their lives every day. But this habit of forming habits also does something else. In academic circles, it’s called the recency bias, and it can trick us into making decisions we might not make otherwise.
The recency bias is pretty simple. Because it’s easier, we’re inclined to use our recent experience as the baseline for what will happen in the future. In many situations, this bias works just fine, but when it comes to investing and money it can cause problems.
When we’re watching a bull market run along, it’s understandable that people forget about the cycles where it didn’t. As far as recent memory tells us, the market should keep going up, so we keep buying, and then it doesn’t. And unless we’ve prepared for that moment, we’re shocked and wondered how we missed the bubble.
When the market is down, we become convinced that it will never climb out so we cash out our portfolios and stick the money in a mattress. We know the market isn’t going back up because the recency bias tells us so. But then one day it does, and we’re left sitting on a really expensive mattress that’s earning nothing.
The point isn’t that you should have predicted the timing of the bubble or the upswing but that you should have considered both possibilities as potential outcomes and planned accordingly. Instead of taking the long view and considering as many factors as possible (the market goes up AND down – it’s what I always say to folks who ask I think the market will do), we settle into a rut and keep behaving as though nothing will ever get us out of it.
Being prepared and recognizing that the bias exists costs very little. I think of it like the winter weather kit anyone who lives in the mountains should keep in their car. Even though I’ve never been stranded traveling in the winter, I know I should have a kit in the car with water, food and other stuff to help me survive if I do. We’ve got to get over this idea that because something has never happened (not in the last six months anyway) that it won’t happen in the future.
All things considered, it’s pretty easy to put some plans in place to help see us through the ups and downs. So quit letting yesterday be the only thing to determine what you do tomorrow with your money.
Let’s look at some charts to solidify this point in our brains. This first chart is the last 5 days of the DOW. Yep! On Friday, the roller coaster ride left our stomachs on the ceiling.