What We're Thinking: Powerful Market Forces You Can Use

There are dozens of forces that impact markets 24 hours a day. In this note, we’re going to cover two big ones: Recency Bias and Regression to the Mean.

We’re all subject to these forces, especially if we think we’re not. Knowing this can help us make useful strategic and tactical choices in life as well as personal finance. No spreadsheet required. The answer is not in cell F28.

Recency Bias

Recency bias, or availability bias, is a cognitive error where people believe that recent events will occur again soon. This tendency obscures the likely probabilities of events occurring.

This is what causes a sharp increase in new earthquake insurance policies after a major temblor. It’s what causes investors to “throw in the towel” after another failure of prices to begin recovering from a fall. And it’s when investors succumb to FOMO during a market advance, thinking that “this is going to go on for a long time and I need to get in.” Recency bias transforms us from investors to gamblers.

So, how can you recognize when you might be affected by recency bias and what can you do about it?  

• You’ll start thinking that maybe your investment strategy isn’t working. But that’s actually evidence that it is working. No strategy works well in every market environment. So, don’t take a recent stumble as evidence that everything needs to change. The best long-term strategy is to stick with your long-term strategy.

• Consuming large doses of media coverage makes you vulnerable to recency bias. Media always   focuses on the worst aspects of the event of the moment. And every day there’s a new moment or new event. What can you do about that? Cut your news consumption. News is like sugar for the mind. Zero is a good target.
  

• Know why you have the investments you have. Learn how they behave. Rely on the long-term evidence. For example, 2022 was unkind to proven, robust strategies like the 60/40 portfolio. Media got all over it. But they failed to tell you that since 1980, 60/40 has had a positive return 83% of the time, and has never had a negative return in any rolling 10 or 20 years. Take the long bet over recent disappointments.

 Regression to the Mean

This is a statistics thing, but we’ll keep it simple. All it means is that when a single reading is far away from its long-term average, future readings will tend to move back toward the average.

The US stock market has a long-term average return of around 10% a year. But there’s never been an average year! Returns are often close to the average, but occasionally, they are far away. Far away readings are great indicators that future outcomes are more likely to be closer to average.

Three recent examples are inflation, national real estate prices, and international stocks. 

Long-term, inflation averages about 3%. We all know it’s been higher than that lately. Regression to the mean suggests we’ll move back toward 3%. 

National real estate prices have risen by over 50% in the last five years. That’s far above the historic average. Regression to the mean (about 15%-20% over five years) doesn’t mean there has to be a crash. A long period of ordinary will do. 

International stocks. While US stocks have turned in near average performance, internationals have seriously lagged. Regression to the mean points to better times ahead for internationals. That may have already begun. Since last October, US stocks are +14%, internationals +26%.

Here’s how to use regression to the mean to your benefit:

• Notice when there’s a lot of excitement about something. The excitement can be positive or negative. The point is that excitement is usually an indicator of far-from-average performance. In early 2020, at the onset of Covid, stocks fell by over 30%. Historically, such a move has just been a set-up for a sharp countermove. Sure enough, stocks more than doubled in the next 18 months. Excitement cuts both ways. Be skeptical of widely popular emotional extremes.

• Huge gains (and equally huge losses) start at the ends of the bell curve. In statistics, these are called “tails.” So, it can be worthwhile to notice when things appear to be at a tail. The prior examples of inflation, national real estate, and international stocks are actually places where recent performance has moved them toward tails. 
  

• Take a long view. The short run is a jumble of distractions, noise, misinformation, pain, suffering, and terror. Pessimism flourishes in the short run. But in the long-run, things do get better. Every economic and financial downturn has been the base for a new advance to all-time highs. Without exception. And every economic and financial advance has sown the seeds of its own correction, adjustment, consolidation. Without exception. The long view keeps us going.

If any of this stirs you or raises questions, or even objections, we’re here to talk about it. Here’s our contact information.

 James Cosgrove, CFP, Plano, TX jim.cosgrove@verizon.net 972-489-0262
Jim Cosgrove, Partner, San Jose, CA jimcos42@gmail.com 408-674-6315 Twitter@JimCos542

Evidence-based. Rules-driven. Policy-focused.