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Observing a Correction: Recency Bias

Over the last few months I have watched the stock market closely.  No, I’m not closely watching my portfolio value.  What I am doing is observing the behavior of others through a correction.  If ever there is a case of recency bias, this is it.

What is a Correction?

The last two corrections of the stock market happened in  April and January 2018.    A correction, in Wall Street terms, is a decline of 10 percent of the stock market from its most recent peak.  By this definition, as I write this in early December we are in a correction.  

Corrections are Normal

These type of market actions are fairly common, happening on average every few years.  This year we had more than one.   The unique part about this one is,  I’m paying close attention.  As noted I’m not doing this to observe my portfolios value, that would be a foolish idea prone to driving poor investing behavior.   No, this time I am observing the behavior for curiosity sake.

I find it pretty interesting too.  If you read forum commentary and the news media you would think the sky is falling.  Questions about what to do when your account loses money or even proclamations about the death of certain market sectors are rampant.    The articles scream of all the lost money.  After all, 10% of a large portfolio is a lot of money.

Are Corrections a Meaningful Measure?

And yet this whole scenario has me questioning the value of tracking corrections at all.    Let’s start with a wake-up call.  The market is down 10% from its high for 2018.  That being said, as of this writing, it is nearly statistically insignificantly changed from where it was on January 1st of this year.  If you go back to 1 year ago today it is actually insignificantly up for the year!  In fact, compared to the lowest point of 2018, April, the S&P 500 was actually up 3% for the period ending now.  And yet everyone acts like it’s the end of the world.  It’s a very interesting case study on recency bias.

Less than Expected Decline

The funny thing is I myself wrote a post during the April crash asking if it was time to execute market timing.  Despite the somewhat tongue in cheek title, the implication of the piece was that many in the world believed the market was on a downward trend.  I basically wrote that no one knows what the market will do next, so hold tight.  And you know what had you bought that day those funds would show a gain.    Yet it’s panic in the streets if you read some of the articles today.  It’s quite comical when you take a step back and realize reality.  Society is so psychologically invested in the last high stock price we forget that if you invested your cash before December 9 of 2017 you’ve received a positive return. 

The reactions of the media and investors are a little scary.    When we began this year with talks of a downturn I have to admit I found it feasible.  I still didn’t change my investments given the poor track record of prognosticators predicting future market gyrations.  But I have to admit I took action to shore up other areas of my financial life just in case a recession was on the way.    And by a recession, I mean a plausible real pullback of both the stock and job markets.    Something on the manner that would push stocks back in valuation a few years, not a few months.  Something where job markets might tighten a bit and some companies might cut back on hiring and salaries.  You know real concerns to the majority of people.

A Recession has Not Materialized

Yet none of those real concerns materialized.  And yet because of that recency bias collectively investors are having heart palpitations over a yearly return of essentially 0.    And that is the scary part.  If people are so ill-prepared or worried about a correction to a few months ago, what will they do when we have a real decline to values seen years ago?

A Gentle Reminder to Stick to Your Investment Policy Statement

Now seems as good a time as any to give this reminder.  If you feel any stress or concern at all over this year’s correction, it’s time to reassess your asset allocation.  Your asset allocation is designed to help you sleep comfortably with major corrections and recessions.  You know the ones where the market drops 25% and layoffs start occurring.    These happen fairly regularly in the economy and you should be adjusting your risk tolerance to handle these situations.  You shouldn’t even notice a correction like this year, unless of course you are like me and enjoy people watching.  So for those who read and are experiencing any type of angina about the current stock market, consider it a reminder to get your asset allocation in order before we hit a real bump.

A Question

For anyone else reading this who like me is shrugging off the change, a question arises.  As I observe this behavior I begin to wonder if a correction is really a viable means of monitoring market behavior.    On the one hand, one could make the case that a 10% decline after a year with a 20% increase is shrug worthy for anyone who has been investing for more than a year.    But what about a 10% decline after 3 years of incremental 5% increases?    One could argue the sunk cost fallacy dictates that it doesn’t matter if the 20% increase came over one year or 3, you still lost the money.  And yet, easy come, easy go.   It seems much easier to swallow something that just appeared in your account overnight.  

Anchoring Bias

Then again that is the appearance of another bias which I myself am exhibiting.   Anchoring bias is when you compare new values to an arbitrary number, whether it occurred last week, last month, or 10 years ago.     Using that value as a basis of comparison of what happens next is a completely baseless comparison.  Your choice of investments should only reflect whether you expect the investment to do going forward, not past performance.

Our Performance Over the Last Year

But then again it doesn’t negate the point that most people with large portfolios executing buy and hold have seen no real change in their assets.  For reference, the Full Time Finance portfolio of investments is down 2% for the year since January 1 and up 2% since December 9, 2017.  Not exactly a shocking number up or down.  Even at our portfolios size the change is less than our contributions for the year.  

So what do you think, is there a better way to monitor stock market moves than a correction?  Are you currently experiencing anxiety over recent market performance?  If so have you considered you may not be invested correctly?

6 Comments

  1. Rich
    Rich December 18, 2018

    FTF — it does depend greatly on what one is reading when referring to the behavior of others. You referenced forum commentary and news media. However, in other parts of the ecosystem — especially FIRE blogs and traditional financial advisors — I see the opposite: complacency. A big shrug. There is an unwavering belief in many circles that US stock market indices will always and forever earn 7-10% over long terms. Perhaps that is possible but I’m not sure I’d bet my family’s future on it at any valuation.

    One point where I agree wholeheartedly: “Your choice of investments should only reflect whether you expect the investment to do going forward, not past performance.” To me this is the key. Every asset, whether an index or a car or a house or a tulip, has a valuation. A valuation is not a predictor of near term performance but can indeed tip the odds in one’s favor. If one buys something fairly valued or undervalued, one is likely to reap rewards. If one buys something overvalued, one is likely to lose. When it comes to stocks, we should at least be asking: “Are stocks overvalued or undervalued, why or why not?” That would be a normal question when investing in anything.

    In full transparency I’ve been bearish for a long time and have been saving dry powder to invest as valuations come down. I’m not expecting to call tops or bottoms, but to me a sound process is more important than perfect outcomes.

    Just my two cents! –R

    • FullTimeFinance
      FullTimeFinance December 19, 2018

      Hi Rich,
      Been a while. Hope things are going well.
      I agree that a belief that markets will return 7-10% forever is another form of recency bias. A downturn will eventually occur, that’s inevitable. When is the only question..

      I believe that one’s asset allocation should reflect that possibility as it’s ever-present. That being said I’m not really on board with the dry power thing. In order for dry powder to be valuable you have to get it right twice, once when the market hits top and once when it hits bottom. The statistics don’t back any of us being able to do that reliably. We could easily drop another 20% from here. Or this could be another example of 2015 or 1996. In both cases, many people felt the market had hit a top. We have yet to return to that 1996 level despite the bubble burst in 1998.

      What is your trigger to buy and what is your trigger to sell?

      • Rich
        Rich December 20, 2018

        Great points. Still love your blog, I’ve been pretty busy at work. Glad the holidays are here! I’ll try to answer, it’s a fair question.

        However, I think there is another assumption / bias before we get to buy triggers and sell triggers in stocks. Put simply: We (in the US) are biased toward stock market investing. I understand that the stock market has become the de facto vehicle for investing and retirement accts (and there are good and bad reasons for that), but personally I challenge the assumption altogether. Why do people *need* to invest in stocks?

        I prefer to start with a blank slate. I don’t need to invest in any particular asset, whether stocks or real estate or bonds (stocks are not in a special category in my mind, other than the ease of investing). I don’t need to match stock market returns or beat the market (“get it right”). That’s confusing the process with the goal. What I need to do is invest in order to meet personal financial goals.

        Therefore, I *want* to invest in assets that are likely to either produce income or appreciate in value. As I mentioned, every asset has a valuation or relative value that can be considered. There are nuances to each asset. I’m not going to invest in a rental house if I don’t understand the housing market. Same goes for commercial RE, private equity, local businesses, etc. I’m not saying it’s easy.

        My perception is that people think stocks are different, that they need to allocate money there and it doesn’t require critical thinking (i.e. one doesn’t really need to know the factors that go into equity valuations). To each his own but that’s not the way I think about it.

        So … finally to your question. My trigger to sell stocks in the first place (a while ago) was high valuations / multiples. Valuations were supported by unusually low interest rates and increasing national / corporate debt levels. As stock prices rose, investing in stocks became increasingly risky. The Shiller PE, for example, was higher in 2018 than at any time in history other than the tech bubble. Other measures had valuations even higher than the tech bubble. As the cycle has progressed, we are seeing valuations (and the supportive debt levels) decrease as extraordinary monetary policy is unwound. It makes perfect sense that stocks are coming down, I don’t think I’m saying anything controversial.

        I’ve already started thinking about my buy triggers. There are a range of factors (market psychology, P/E multiples, etc) that I’ll be watching. For long term money, I’ve set some price targets for the indices, so that I’ll be disciplined enough to buy bigger chunks as prices come down. I do think dry powder is valuable, and I don’t need to be exactly right to make a sound investment. More importantly, my goals are not dependent on my getting it exactly right. If it’s a bear market, there will be plenty of opportunities to buy.

        I know this was a long answer — some readers will probably think, “Eh, Rich, you’re making this way too complicated!” Fair enough 🙂 I enjoy investing and I don’t mind the research. But the bottom line is I’m not personally going to put hundreds of thousands of dollars into an investment (or hold that investment) without understanding its valuation. I don’t want my life savings to be dependent on bubbles or the irrationality of others. If someone can convince me that valuation NEVER matters … I’ll reconsider my thinking.

        Does any of that make sense? If you disagree, is there ever a price at which you’d consider selling equities?

        Related blog posts:
        https://www.pennyandrich.com/rich-plan-stocks-opportunity-fund/
        https://www.pennyandrich.com/rich-market-psych/

        • FullTimeFinance
          FullTimeFinance December 20, 2018

          Interesting and well thought out comment. Rather then answer in a comment I think I’m going to respond in a post. Look for it in about 2 weeks. For now, I will say I agree with your general construct, that there is a point where one would sell equities and equities are not the only investment option. That does not mean I like dry powder.

  2. Xrayvsn
    Xrayvsn December 18, 2018

    There are so many psychological factors at play that cause an investor to sometimes make rash decisions and really hurt their finances.

    It is difficult to not jump ship when everyone else is screaming sell sell at you on the TV and you see the markets start rapidly declining in value. But this is where people can make money (aka Warren Buffet types) when they swoop in and get things on sale.

    • FullTimeFinance
      FullTimeFinance December 19, 2018

      Very true. Or at very least not lock in the short/mid term loss.

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