The third in a multi-part series about a key investment issue
I have touched on the subject of ‘behavioural investing’ in the past, notably in my discussions about loss aversion and herding.
Recency effect is important because, in many respects, it seems so obviously true when in fact it’s so frequently false.
‘It’s an interesting effect,’ writes Dan Ariely, James B. Duke Professor of Psychology and behavioural Economics at Duke University and author of The New York Times bestseller, Predictably Irrational: The Hidden Forces That Shape our Decisions.
‘We look at the most recent evidence, take it too seriously, and expect that things will continue in that way.’
Think about the wildebeests
There’s an evolutionary advantage to this. Think back to the origins of humanity somewhere on the African savannas: If the wildebeests show up at the same watering hole a few days in a row, odds are we’re going to hunt at that same spot the next day.
Nowadays, though we’re hunched at computers instead of hunting game, we still instinctively seek patterns in the events that have happened most recently, while memories of older occurrences have less influence over our behaviour.
The wildebeests don’t always come back
The problem, of course, is that the wildebeests don’t always come back. And that makes recency effect particularly dangerous for investors. Adds Dan Ariely: ‘If you think about the creation of asset bubbles, that’s always what happens. Things go up and up and up, and we start thinking it has to always go up.’
Stock market professionals are hardly immune to this trend.
At the beginning of 2008, trouble signs were emerging in the global economy. But after five straight years of positive returns, sentiment among equity analysts neared an all-time high, with the Wall Street consensus calling for continued gains.
Those calls were based in part on – you guessed it – analysis of the recent past. What happened next? The economy went off a cliff, and the S&P 500 fell 38.5% that year.
The value of a long-term investment plan
We encourage our clients to maintain a long-term investment plan, because it’s one of the best defences against recency effect.
Your long-term asset allocation targets should reflect your investing goals, tolerance for risk and cash needs. Periodically, you may need to reassess your expectations for the long-term performance of various asset classes, but any resulting changes to your allocation should be modest.
Use valuation metrics such as price-earnings ratios to bring objectivity to your analysis. Also, think ahead about how you should respond if a position exceeds your expectations or suffers a surprise decline.
The recent past may be fresh in your mind, but putting it in the proper context can keep it from having an undue influence on your investments.
Dave Ritcey, The Ritcey Team, Scotia Wealth Management