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Explaining Recency Bias in Stock Market Investing

Part of the reason big money is made in growth themes and distress themes is because they are so ignored that the early investors and players made the most.

However, the human brain is wired in such a way that not many allow themselves to evaluate things objectively.

Take the case of these examples here.

  • Many would have said that gold at $1500 is expensive now but back in 2003, we were able to buy it for around $200-$300. Gold have been in a bear market for almost 18 years. Not many would have considered owning gold then.
  • I was talking to my colleague and pose a question to him:”Would the interest rate on our savings deposit ever reached 5%?” His exact answer is “Not a chance.” Readers would note that in the 1980s to combat high inflation saving interest rate did reached 4%. Almost the exact scenario bringing high gold prices currently.
  • I read this great article written by James Montier on Immutable Laws of Investing. In the article it mentioned that in Aug 2000, Fortune magazine came up with a list of “Ten Stocks to Last the Decade” or the sort of buy and forget portfolio. That portfolio was made up of ten stocks: Nokia, Enron, Oracle, Broadcom, Viacom, Univision, Schwab, Morgan Stanley and Genentech. Those stocks are heavy on tech, which is the theme of investing post dot com bubble bust. Fortune Mag probably drafted a portfolio heavy with the stocks that has the strongest business model then.

What happens here is that our human brain is condition to believe that what happens in the near term will be the most likely possibility and those situation where they have never experience before would not likely happen.

You likely invest in ETFs for long term thinking the market will always go up because it has been going up for the last 10 years.

Well what happens if you are right next to a secular bear market? Experts say that the cycle for secular bear market last for 17 years. For Drizzt that means he potentially have to wait until he is 48 years old before the market recovers. Who knows how much stupid things you will do in that time.

The reason those folks who made the initial calls were rewarded was because they are either lucky if they made enough prediction or they are rewarded in able to process the vast amount of information to come to a decision why this time it is indeed going to change.

Reading articles on the thought process of people who come to a decision to invest in gold, short the real estate market shows that as an investor it is important to be able to:

  • Grasp a general understanding of the norm environment. This is what most people is able to deal with. After all we are being bombarded with such knowledge of the norm.
  • Take a lead and quantitatively analyze why it may be different this time. Instead of just saying that this time it is different, these people believe that if such a trend is indeed taking place, data should be able to substantiate or disprove this.
  • Think out of the box. Having a brain that can gather all the data collected, turning it to knowledge, process them and concluding whether the trend has change is important here. I guess that’s why those folks were rewarded because they can do it much better than us.

Sometimes we really prefer the easy route where we follow the herd and earn a nice return. Doing the above would be fast too much work for our brain. If you are interested in protecting your portfolio or finding the next big thing, you got to at least eliminate this recency bias from your thought process first.

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Sunday 5th of June 2011

Interestingly, the historical high of 20.00 percent is in January of 1990 and a record low of -0.75 percent is in October of 1993

So don't assume future interest rate cannot rise higher than 2-3%. One should see the chart for yourself


Tuesday 7th of June 2011

how do you see interest rates moving Createwealth8888?

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