29 Aug The Thanksgiving Turkey
“Something has worked in the past, until – well, it unexpectedly no longer does, and what we have learned from the past turns out to be at best irrelevant or false, at worst viciously misleading”
-Nassim Nicholas Taleb
In ‘The Black Swan’ Taleb introduces us to the Thanksgiving turkey. Every day the bird wakes and is provided with food, shelter and water by its human benefactors. It wants for nothing. As far as the turkey is concerned, this is what its life consists of. A pattern repeated daily, for months, it has no reason to believe that the future will be any different to the past. Then a couple of weeks before Thanksgiving…
It’s not just turkeys who are susceptible to this problem. We all tend to ‘learn backwards’ as Taleb describes it. We all assume that if something has repeated in the recent past it will continue to do so in the future.
This tendency to believe that what has occurred recently will keep happening is referred to as ‘recency bias’ in behavioural finance terms.
Recency bias permeates all aspects of our lives. Consider anything with ‘The x greatest ever…’ in its title, where the list has been voted for by the general public, such as this one – the top 20 pop songs ‘of all time’ yet not one entry dates back further than the 1980s.
Another classic example is the tossing of a coin. A pattern of H H H H T T H T T H has the same probability of occurring as H H H H H H H H H H, yet in the case of the second pattern occurring we are much more likely to believe that the next coin toss will result in another heads.
To add insult to injury, once an outlier event occurs which we failed to foresee, we tend to believe it will happen again. Following the stock market crash of October 1987 many investors expected history to be repeated in subsequent Octobers. There are investors who have been sitting in cash since the financial crisis in 2008/09 because they were convinced the market would plummet again. That’s an extremely costly mistake to have made.
When you bear in mind that 90% of all the data which exists in the world has been created in the last two years it’s no wonder that we find this behavioural trait so hard to keep in check. Fortunately, as an investor, there are several steps you can take to mitigate its effects.
Firstly, and most importantly, accept that there is no such thing as a pattern of returns when it comes to investing. Don’t believe me? I give you, Exhibit A:
Source: Callan Associates
As I have said many times before on this blog, diversification is your friend, and the only truly free lunch. The market does not know how diversified (or not) you are, and it doesn’t care.
Actively seek out contrary opinions to your own. Recency bias is often accompanied by its good pal confirmation bias. Together they can be a lethal combination so try and avoid living in an echo chamber.
Ignore the soothsayers and market forecasters. They have a terrible track record and have no more idea of which way markets are headed than anyone else. If anyone ever truly discovers how to predict market movements in advance they won’t be sharing that information with you, they’ll be too busy getting rich.
Manage your portfolio using a robust, evidence-based process. Rebalance when it gets out of kilter (and make your rebalancing process rules based as well). This will force the discipline of banking profits from recent winners and reallocating capital to recent under-performers and will help you to avoid doing what most investors do which is to chase performance by continually buying yesterday’s winners.
If you don’t think you have either the necessary time, discipline or emotional detachment to do this yourself, consider working with a financial planner who will do this for you in the context of your financial plan. It may be money well spent.
“After seeing a movie that dramatizes nuclear war, they worried more about nuclear war; indeed, they felt that it was more likely to happen. The sheer volatility of people’s judgement of the odds–their sense of the odds could be changed by two hours in a movie theater–told you something about the reliability of the mechanism that judged those odds.”
― Michael Lewis
Carolyn