Recency bias

 
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Overview

The Party Effect or Recency Bias is where stock market participants evaluate their portfolio performance based on recent results or on their perspective of recent results and make incorrect conclusions that ultimately lead to incorrect decisions about how the stock market behaves. This is a very important concept to understand. Let’s set the stage for an illustration of how this happens.

Examples

A Party Tale

“You’re Right”

One of my favorite life lessons centers around President Franklin Delano Roosevelt, also known as FDR. FDR had many strengths but I think his greatest was his ability to recognize that things are not always black and white. I think his ability to see the big picture as well as discern the subtleties of a situation is what made him such an effective leader and brought out the best in others.

In one well known FDR story, he asks one of his trusted advisors what he thinks about a particular situation and after he listens to the advisor, FDR replies “You’re Right.” Not long after FDR asks another of his trusted advisors for his opinion on the same matter and this advisor gives the exact opposite recommendation from the first advisor to which FDR once again replies “You’re Right.”

At hearing FDR’s reply to the second advisor one of FDR’s closest advisors that had listened to FDR’s response to both advisors, points out the obvious contradiction to which FDR replies “You’re Also Right.”

Much can be learned from what at first appears to be FDR’s flippant and contradictory remarks to his advisors. However, FDR was far wiser. FDR understood that all three advisors were in fact right. They were just right from their perspective. But they didn’t have a view of the big picture. The contrast between FDR’s perspective of the entire situation compared to the trusted advisor’s perspective of a narrow part of the situation is what creates the dichotomy. The stock market works much the same way.

A different example would be the poem about the six blind men and the elephant. Each of the six blind men is asked to describe an elephant. Their perceptions lead to misinterpretation because they each describe the elephant differently depending on which part of the elephant they touch. One touches the side and describes the elephant like a wall. The other the tusk and describes the elephant as a spear. The next touches the trunk and describes a snake. The next the knee and describes a tree. The next an ear and describes a fan. Finally the last touches the tail and describes the elephant like a rope.

This tale is about the stock market and how investors relate to the stock market. The stock market can be viewed as FDR or the elephant while investors or participants in the stock market can be viewed as the advisors or the blind men. When describing the stock market each participant sees their portfolio’s performance from their perspective only and thus they are always “right” which leads to what I call The Party Effect or what Financial Behaviorist call the Recency Bias.

Imagine that you attended a party hosted by your investment advisor and that in addition to you, also in attendance were several other clients. As you go around the room and meet people you learn that everyone at the party owns the exact same S&P 500 index mutual fund. I use the S&P 500 for this tale because by many measures it has historically produce an average rate of return of about 12% and as many people know, and now you know as well, it represents what many investors call “the stock market.” The question then is would everyone have the same rate of return at this party? Of course the answer is, no they would not. If they started at the same time they would but since people invest or come into the life of the investment advisor at different times, the answer is no.

Let’s tighten up the party attendee list and invite only 30 guests. For simplicity, let’s assume that Guest 1 purchased the fund 30 months ago, that Guest 2 purchased it 29 months ago, that Guest 3 purchased it 28 months ago, etc. What would the guests discuss? What would be their perspectives of the stock market?

In order to determine what the guests would discuss and how they would evaluate their performance we need to have some data in the form of monthly rates of return. So we need to develop a monthly rate of return for 30 months to see what they see. Again, for simplicity, assume that for the first 18 months the fund goes up 3% per month and for the next 12 months it goes down 2% per month. Please note that I didn’t pick this sequence of numbers randomly. I have a purpose to this. This particular sequence approximates how the stock market moves in terms of bull and bear market duration and after 30 months returns approximately 12%; 12.28% to be exact. This sequence of numbers is a good sequence to illustrate The Party Effect or Recency Bias. We can characterize the first 18 months as the bull market phase of the 30-month cycle and the last 12 months as the bear market phase of the 30-month cycle.

To illustrate The Party Effect lets focus on 4 guests and see how they describe the stock market. Remember the FDR and elephant example from the start of this tale. Let’s look at guests 1, 10, 19 and 25. I picked these 4 because readers of this tale can relate in some form or another to one of these 4. Guest 1 started 30 months ago, at the beginning of the bull market phase, and his rate of return is 12.28% for the entire 30-month cycle. He enjoyed the ride up for 18 months and now the ride down for the last 12. Guest 10 started 21 months ago, halfway through the bull market phase, and his rate of return is 1.36% for the 21-month period he has been invested. Guest 19 started 12 months ago, at the beginning of the bear market phase, and his rate of return is –21.53% for the 12-month period he has been invested. Finally, Guest 25 started 6 months ago, halfway through the bear market phase, and his rate of return is –11.42 for the 6-month period he has been invested.

These 4 guests experienced entirely different rate of return outcomes and view their portfolios and thus the stock market completely different. All 4 are correct. All 4 are right and yet they couldn’t possibly have more divergent outcomes. If they don’t have a complete picture of the stock market, like the elephant, they can get themselves in trouble. The difference between the best performing portfolio that is up 12.28% and the worst performing portfolio that is down 21.53% is an astounding 33.81%. Is this too obvious? You may say, of course they have different outcomes, they started at different times but that is not the point. The point is that stock market investing will always produce different outcomes. One guest started at the worst time possible. Another guest started at the best possible time. How they look at the past determines how they see the present. Most importantly, it will determine how they will act going forward.

The Party Effect simply states that stock market participants evaluate their portfolio performance based on their perspective and their perspective only. They do not see the market as it is but as they are. Without an expert understanding of how the stock market works, this leads to incorrect conclusions that ultimately lead to incorrect decisions. The field of Behavioral Finance (BF) has shown time and time again that people have variable risk profiles. BF demonstrates that fear is a stronger emotion than greed. This means that in our simple 4 guest example, Guests 3 and 4 are more likely to exit the stock market at just the wrong time since their recent, thus Recency Bias, experience is one of losing money. It means that Guest 1 and 2 are more likely to stay invested, thus catching the next wave up that is likely to follow. All 4 have intellectual access to the events of the last 30 months. All 4 can educate themselves on the stock market. However, their particular situation is so biased by recent events that the facts are unimportant. They behave irrationally. I have witnessed this irrational behavior throughout my career. No one is immune, even advisors.

There are ways to combat The Party Effect trap but it is the deadliest of all the stock market traps that I know. Few can overcome it. The only sure way to overcome it is to become an expert on the stock market yourself, learn to manage your emotions, and then either manage your own money or hire competent managers that you recognize are expert in their chosen investment discipline. However, if you hire an expert on the stock market you have not solved the problem if you do not have expertise. Let me repeat this sentence and highlight it. If you hire an expert on the stock market you have not solved The Party Effect trap if you do not have expertise yourself. When you hire an expert on the stock market without being an expert yourself all you have done is added complexity to a complex problem. You have inserted another variable between you and the stock market. You now have three variables to worry about, the stock market, your advisor and yourself. Without expertise you have no way of knowing if your advisor is an expert. You are in an endless loop. You are in a recursive situation. Just like we ask, what came first the chicken or the egg? The Party Effect asks, how do I hire an expert without being an expert myself?

If you are unwilling to become an expert on the stock market you must find a way to solve The Party Effect trap? How do you do it? As a first step I suggest you read An Expert Tale to make sure the person you hire is in fact an expert and then hire them. The original intent of my Financial Tales project was to educate my kids and others I love. With that as a backdrop, this means I highly recommend you avoid dealing with any advisor that does not have a fiduciary relationship with you the client. Why, because you are adding a 4th variable to an already complex situation. You are adding the ever present conflict of interest that every non-fiduciary advisor has with their client. This 4th variable makes a successful outcome all but impossible. I recognize that these words are harsh but I believe your odds of success drop dramatically once you introduce the non-fiduciary variable. I don’t know what the future holds, but today you must avoid conflicted advisors at firms such as Merrill Lynch, Smith Barney, Morgan Stanley, etc. I expect that the non-fiduciary model of providing people with investment advice based on the size of the advertising budget will go the way of the dinosaur, but for as long as it exists, you must avoid this ilk of advisors.

What is the second step to avoiding The Party Effect trap? There is no second step. You either develop investment expertise or you learn to recognize experts and hire them. You can’t avoid or abdicate this charge. You must embrace your responsibility or you will suffer or those you love will suffer. It behooves the reader to invest their time in what is one of the most important decisions they will ever make and must make every day.

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