What do current trends tell us about the future?
By: Sam Swift, CFA, CFP®
It’s June here in the desert which means the heat is rapidly approaching. In fact, our May was so mild compared to usual that it was almost as if the heat hit the snooze button. No matter—it’s awake now and making up for lost time. Tuesday this week was 92 degrees, followed by 95 degrees on Wednesday. Today is expected to reach 102 degrees…Friday is supposed to be 109…and Saturday 113. That’s a lot of degrees. The joke around town is that if current trends continue we’ll be looking at about 178 degrees before July 4th!
We know that isn’t the case, of course, but embedded in that sentiment is an actual behavioral fallacy investors frequently succumb to: recency bias.
When things are going well (or poorly) in the market, we tend to think it will continue the same way into the future. Our brains are programmed to weigh whatever just happened as exponentially more important than something that happened a year ago or longer. This behavioral bias is amplified by the daily news media. The news is a lagging indicator—it’s simply telling us what already happened and attempting to explain it. This has the effect of smothering us with current events and blinding us to longer-term trends. Combine this with the negative bias of the news and our own aversion to loss—that is, the fact that a loss hurts far more than the relative pleasure from a gain of similar magnitude—and it’s very easy to become engulfed in a negative spiral. As usual, the best thing to do is to keep your distance from the sucking vortex in the first place. When we remove ourselves from the emotional attachment to our money, we can see a few real world examples that highlight the fallacy of recency bias.
With the roulette wheel, for example, it’d be silly to assume that six reds in a row means that more reds are on the way or that a black is imminent—the next spin will still have 50/50 odds (or 47.4/47.4—stupid green spots). We can’t predict the next number, but we know that over time it will be pretty close to 50/50 red/black. The long-term prediction is relatively easy to make whereas the short-term prediction is gambling—quite literally in this analogy.
It’s the same with the weather. It’s tough for us (even if you’re a meteorologist) to predict the exact temperature next week, but we do know general long-term trends—it’s going to get cooler in the fall and winter before it gets warmer again in the spring and summer.
With the market, we know we can’t predict prices for the next day, week, or year successfully, but we have strong evidence pointing to broad trends. Most importantly, whatever has just happened has little bearing on the long-term path so we can’t overweight its significance. A globally diversified portfolio will very likely be worth more five years from today and will almost certainly be worth more ten years from today.
Every short-term movement in the market will reverse itself at some point—it’s not forever! However, we can trust in the long-term trend that we will be rewarded for taking on short-term volatility. A smart investor will suppress their instinct for recency bias and adopt historical bias instead. It takes much more than a few weeks of data to overturn 90 years of evidence. For you Arizonans, something to think about, at least, while you search desperately for a pool this weekend.