When it comes to investing, rely on long-term wisdom
When it comes to the market’s peaks and troughs, investors often don’t react as rationally as they might think. In fact, in times of extreme volatility or poor performance, emotions threaten to commandeer our common sense and warp our memory.
It’s called “recency bias.”
What the heck is recency bias?
Recency bias is basically the tendency to think that trends and patterns we observe in the recent past will continue in the future.
It causes us to unhelpfully overweight our most recent memories and experiences when making investment decisions. We expect that an event is more likely to happen next because it just occurred, or less likely to happen because it hasn’t occurred for some time.
This bias can be a particular problem for investors in financial markets, where mindful forgetfulness amid an around-the-clock media machine is more important today than ever before.
Try thinking about it this way. In the high-visibility and media-saturated arena of pro sports, every gifted athlete knows that the key to success can be found in two short words: “next play.”
The “Next Play” Philosophy
They know the benefits of short-term memory loss cannot be understated. And from Little League baseball and Pop Warner football to the World Series and Super Bowl, coaches understand that seemingly “clutch” plays are only possible when a player’s memory is a clean slate.
While sports can (and do) provide a helpful example of memory mastery, this practice is also commonly—and profitably—employed in the world of investing. Last year, for example, diversified investors were dealt a subpar hand as small company and international stock performance lagged behind their large U.S. stock counterparts.
If investors stayed disciplined, however, rebalancing their domestic winnings into their seemingly struggling foreign holdings, they’d have been pleased to see the international cohort buoying their portfolio performance in the first half of this year.
But investors have notoriously short-term memories. This creates a gain-sapping inertia that leads buyers to engage at the top and sellers to exit at the bottom.
Recency Bias + Confirmation Bias = Trouble
Recency bias is further compounded by “confirmation bias,” best described as an investor’s selective memory. Confirmation bias leads us to pick and choose the memories best served to fuel our established narrative.
“I’m waiting to get out of this stock until it gets back to [fill-in-the-blank].”
Really? I have some bad news. Regardless of how you remember the market, you can be sure that the market has no memory of you. The market doesn’t know where you bought that stock or mutual fund or investment strategy, and it doesn’t care when you’d like to sell it.
The market is going to do what it’s going to do regardless of our desires.
The best strategy going forward is simply the best strategy going forward—irrespective of what just happened and how well or poorly you performed. Whether you’re the wide receiver who caught the football in the end zone or the defensive back who just got burned for a touchdown, you’ll be best served to forget what just happened on the last play and make the best decision now, in the present.
But how do we know what that best decision is? We employ our long-term memory or, lacking that, someone else’s.
Trade Short-Term Memory for Long-Term Wisdom
Total amnesia is not the goal. While short-term memory can be our enemy, long-term memory, when informed by adequate education and experience, is our ally. Fortunately, in investing, we have the collective long-term memory of scores of brilliant people to draw on.
The challenge, in this information age, is to sift through heaps of articulate financial content riddled with the recency, confirmation and other biases of others in search of academically vetted, peer-reviewed and actionable content based on long-term memories.
While it may be true that no one is entirely objective, if someone is calling for drastic or urgent action, the chances are good that their directives are highly biased. (And if a free meal is thrown in, you can be sure of it.)
Times like now, when markets are on an extended good (or bad) streak, can put our mental fortitude to the test. Headlines that reek of bias can underscore the short-term memories we’re trying to forget.
Long-term wisdom can fade in its appeal as it is increasingly questioned. Rationality, discipline, balance and diversification are out. Concentration, experimentation, impatience and prognostication are in. But they don’t win.
Duke’s (Unfortunate) Success
Duke’s college basketball team, however, does win.
By way of disclaimer, I’ve never watched a college basketball game in which Duke was playing where I wasn’t rooting for the opposition. It almost pains me to laud them in any context, but I just can’t help it in this instance because Duke’s legendary coach, Mike Krzyzewski, may be the chief proponent of a “next play” philosophy.
Regardless of the circumstances—good or bad, on or off the court—Coach K can be heard peppering those under his tutelage with the refrain, “Next play.”
He says: “You cannot do anything for the last play. Someone who is always looking in his rear-view mirror will never make the most of the current moment.”
Yes, of course, talent, hard work, discipline and experience are all important, but they are minimum requirements for success. Those who excel in sports, investing and life must also have a poor short-term memory.
The most compelling findings regarding financial decision-making are found not in spreadsheets, but in science. A blend of psychology, biology and economics, much of the research on this topic has been around for years. Its application in mainstream personal finance, however, is barely evident. Perhaps a simple analogy will help you begin employing this wisdom in money and life: The Rider and the Elephant.
First, a little background.
Systems 1 and 2
Daniel Kahneman’s tour de force, Thinking, Fast and Slow, leveraged his decades of research with Amos Tversky into practical insight. Most notably, it introduced the broader world to “System 1” and “System 2,” two processors within our brains that send and receive information quite differently.
System 1 is “fast, intuitive, and emotional” while System 2 is “slower, more deliberative, and more logical.” The big punch line is that even though we’d prefer to make important financial decisions with the more rational System 2, System 1 is more often the proverbial decider.
Many other authors have built compelling insights on this scientific foundation. They offer alternative angles and analogies, but I believe the most comprehendible comes from Jonathan Haidt.
“You don’t really do this stuff—do you?” The question came from a major network anchor after the camera stopped rolling. The topic was budgeting.
He certainly isn’t obtuse, and he wasn’t being patronizing or condescending. It was a legitimate question that accurately reflects the underlying perception held by most people in any demographic–that budgeting is for those just scraping by and young people just getting started. A tedious chore reserved for those lacking the means to do otherwise. A humble state from which most of us hope to graduate.
But this is a misconception. In truth, the budgeting process can help people at every stage of life and every income level articulate and align their deeply held values with their financial priorities, which is the first step on the path to integrating money and life. However, there is more to be gained from the discipline of budgeting (at least in terms of raw dollars) for those of means. Better said, there is less to be lost by families who earn especially high incomes.
Like the Blue Jays’ Daniel Norris, a good financial planner is true to him- or herself.
“Stop asking questions, Maurer, and do what I tell you to do,” said the general agent for the Baltimore region of a major life insurance company.
“I made over a million dollars last year!”
“I buy a new Cadillac every two years — cash on the barrelhead.”
I was told how to dress: Dark suits, white shirts, and “power ties” that weren’t too busy. Light blue shirts were allowed on Wednesdays. Never wear sweat pants, even to the gym. Enter and exit the gym in a suit. Your hair should never touch your ears or your neck. Facial hair was strictly forbidden. Jeans, outlawed.
“Level is dedicated to rewriting the financial rulebook to create a secure future for the next generation.” That’s budgeting app Level Money’s stated mission, which can be found on their website’s “About Us” page. But even as lofty as that objective sounds, co-founder and CEO Jake Fuentes says the company’s sights are set even higher.
“Basic everyday money management,” he suggests, could be “the first step toward changing—or creating—the next generation’s banking structure.”
An app that hopes to change the way the next generation banks? I’m listening.
April is National Financial Literacy Month, and while I would never argue against financial literacy, I have a fundamental problem with the moniker. Who, after all, would willingly step forward and proudly announce themselves illiterate—at anything?
Unfortunately, I believe that’s what fully embracing the financial literacy movement requires. It positions financial educators as the Dickenses of currency and those who struggle with money as the collective Oliver Twist. Yes, it’s unfortunately true that too many Americans lack optimal—and perhaps even sufficient—personal financial education. But a sweeping declaration that labels the majority of the country financially illiterate does little to advance the cause. And it may even slow the progress we seek.
Simple is hot, even fashionable. But in many cases, it’s for all the wrong reasons. Simple is easier to pitch, explain and sell, and therefore also easier to receive, understand and buy. But when simple devolves into simplistic, becoming a one-dimensional end instead of a user-friendly means, it’s no longer an advantage and may actually be doing damage. Not everything can be turned into a tagline, a rule of thumb or a short cut.
Therefore, when my colleague and New York Times contributor Carl Richards first asked me a couple years ago to think about what a financial plan might look like if it was constrained to a single page, I was skeptical. After all, I’d dedicated my life and work to helping people, primarily in their dealings with money, wholly through the written and spoken word. The fullness of that education seemed impossible to responsibly confine to a single page. Then I read Carl’s new book, The One-Page Financial Plan.
At 208 pages, it may be a tad shorter than most personal finance books, but it’s obviously longer than one page. There is, however, a single page in it that I believe will help you understand why the book was written and how it could benefit you. On page 11, toward the end of the book’s introduction, Richards shares with us his family’s first attempt at an actual one-page financial plan.
Yesterday, a bearded 21-year-old surfer who lives in a 1978 VW bus, and on a self-imposed annual allowance of $10,000, mowed down my beloved Orioles with a 96-mile-per-hour fastball.
Blue Jays pitcher Daniel Norris isn’t striving to make a statement with his apparently Spartan existence. He’s simply choosing to live life according to his priorities. He’s writing his own story.
According to ESPN, Norris’ values system is strengthened by generational ties and rooted in the topography of Johnson City in northeast Tennessee: “Play outdoors. Love the earth. Live simply. Use only what you need.”
The point of this article is not to compel you to adopt Daniel Norris’ values, but to convince you to live by your own. Here are three ways to do so:
Even if you get your daily news from one of those celebrity tabloid shows, you have probably still heard that the market has been more than a little crazy in recent weeks.
Indeed, the typically overstated “surge” and “plunge” headlines have been less hyperbolic of late, as the Dow Jones Industrial Average burps out daily gains and losses in the hundreds of points. But over the past several trading days, the results have been all red, and since Sept. 18, the market has taken back more than 6% of what it’s given so far this year.
Is this volatility the precursor to another market gutting? Or perhaps it’s just a momentary ebb in advance of a continued upward flow?
The answer is yes.
The market is in the business of rising and falling, and of making fools of those who attempt to predict which it will do next. But be sure that we will feel both the pain of another big drop—perhaps sooner rather than later—and the euphoria of another unprecedented gain.
Whether this very recent pullback happens to be the beginning or the end of something, most investors have already lost enough to benefit from it.
Benefit? Yes, you did read that correctly. Here are three ways to gain from market losses:
Exchange-traded funds—commonly referred to as ETFs—are all the rage. While there are several excellent reasons to use an ETF over the seemingly archaic traditional mutual fund, they are not a universally preferable solution.
First, to be fair, let’s review a few reasons why ETFs can be a better solution than mutual funds.
ETFs generally have lower associated costs than comparable mutual funds. This isn’t news, I know, but since costs are one of the few variables over which we have control as investors, I don’t mind flogging this deceased ungulate.
The expense ratio is the most obvious cost reduction. For example, the legendarily inexpensive Vanguard 500 Index Fund has an expense ratio of 0.17 percent, while Vanguard’s S&P 500 ETF has a barely noticeable expense ratio of 0.05 percent. This makes ETFs an ideal choice for investors making a sizable, broadly-based, one-and-done purchase.