Stop playing market whack-a-mole

You’re sitting in your favourite restaurant, feeling famished. The waiter arrives and reads out a long list of mouth-watering specials. Yet the moment he walks away, you find you can recall only the last item on the list. Congratulations, you’ve been struck by the recency effect.

In psychology, the recency effect refers to a human tendency, when asked to remember a long list of items, to have a sharper recall of the last items on the list. No doubt you’ve experienced this at a party. When introduced to ten people, you only recall the name of the last one or two.

Recency in finance

The recency effect occurs in finance, too, although the consequences can be more serious than forgetting whether the potatoes were roasted or fired or who the man in the blue shirt was.

Quite simply, if you are making investment decisions based on what happened in markets in the last week or the last day, you risk chasing past winners or perceiving as the greatest risk something that has already occurred and been priced in.

We have seen that in dramatic terms in recent months with many people turning defensive in March at the peak of the coronavirus crisis, only to see risk assets bouncing back in equally dramatic fashion in the second quarter of the year.

Our cave brain

There is an evolutionary reason for the recency effect. Just as we did when we were hunter gatherers more than ten thousand years ago, our brains are programmed to respond to what we perceive as the most immediate threats. Equally, we are likely to see as the best opportunities those that proved themselves in the immediate prior period.

During particularly traumatic markets, or alternatively, during rampant bull markets, this effect can be magnified. Our short-term memories (the human equivalent of computer RAM) dominate our decision-making process, extrapolating recent returns into the future.

The consequences of this behaviour too often are that people buy stocks at or near the top of the cycle or sell them at or near the bottom. In bull markets, this equates to fear of missing out, while in bear markets the overwhelming imperative is loss aversion.

“This time is different”

Of course, the most common response to those who warn of the recency effect is to observe that this time is different. The view here is that something fundamentally has changed in markets and a more tactical approach is required when everything is so unsettled.

The problem with that argument is that while every crisis is certainly different in one way or another, that doesn’t make it any wiser for investors to base their strategy on what might have been a good approach to the last one.

This ends up resembling a game of whack-a-mole where the participant tries, usually in vain, to push rapidly appearing individual moles back into a hole by hitting them over the head with a mallet. As each mole withdraws, another one pops up somewhere else.

How to respond

So, if this is human nature, how do we resist the impulse to put the greatest weight in our investment decision-making on what happened last?

The answer is in asset allocation and rebalancing. By far the biggest influence in your investment outcomes is how you distribute your money across growth and defensive assets. That allocation in turn is driven by your risk appetite, your goals and your circumstances.

If you have decided at your most rational moments, that your desired allocation is 50% growth (shares, property) and 50% defensive (bonds, cash), then that’s what you should stick with. If shares fall 30%, your allocation may look more like 45-55. If you respond to the market fall by selling down shares and buying bonds, you might end up with 40-60.

In other words, the recency effect can drive you away from your target portfolio by encouraging you to change your strategy based on a small sample size over a short period. This is like a pilot who responds to turbulence by completely changing course.

The value of rebalancing

A better response is to rebalance. If stocks have fallen sharply during the intervening rebalancing period, the adviser at the next opportunity will sell some bonds and buy stocks to bring your desired asset allocation back on target. Likewise, if stocks have done very well, he may sell some stocks and buy bonds.

The important point is your investment decisions are based this way on your risk appetite, goals and circumstances, not on what happened in markets in the past quarter.

So put the mallet away. There will always be a mole popping up somewhere. Just leave the little rascals alone.

Source: The Evidence-based Investor (TEBI) www.evidenceinvestor.com