Your Brain on Drugs...err, The Market
We've had an interesting week in the market. At least it seems that way. At the time of this writing, the Dow is sitting at 25,642, down 508 points (2.08%) for the day. It was down 362 points on Tuesday, or 1.37% in percentage terms. Couple that with it being off a little Monday, too, and some folks are starting to get a little antsy as the market is headed towards it's worst week in 2 years.
The prevailing opinion among my clients and friends the past few months is that we've seen a nice run up in the market, and maybe we should start to get worried that we're in a bubble and headed for a collapse. On the surface, that seems fair. For people my age or close to it, a short history of investing has looked something like this:
1997 - 2000: Massive run up in stock prices, everyone is getting rich. Buy, buy, buy!
2000 - 2002: Tech bubble burst, massive drawdowns, financial ruin everywhere.
2003 - early 2007: The stock market is back! The value of my home is through the roof!
late 2007 - 2008: Financial crisis and massive unemployment, 55% drawdown in stocks, I'm underwater on my house, financial ruin everywhere. (Felt longer than that, huh?)
2009 - Present: Although I'm constantly nervous, this is an amazing run for the stock market. It's up almost 400%. Something has to go wrong.
When the market starts to turn down, it feels like it's never going to stop and it's time to pay the financial piper. Our brains are designed to work like this.
Pattern Recognition & Recency Bias
So why do we feel that way? Unfortunately, there are a few extraordinary powers of the human mind at work, and none of them are really going to lead you to the correct decision on what to do with your investments.
Human beings have an innate and almost hyper-sensitivity to recognizing patterns. Our ability to communicate and operate intelligently is dependent upon it.
If you've ever watched a toddler learn words and concepts, you can almost see the brain neurons firing as the small child starts to recognize patterns for differentiating between objects. Intelligence, then, is really just a matter of being able to store more patterns than anyone else. ~ Dominic Basulto
Well, that's pretty awesome. Good for us! But it's not always helpful. Sometimes this amazing trait can lead us to see patterns that aren't useful in any predictive sense. One of those is easily identifiable through flipping a coin.
If you saw someone flip a coin a series of times that went -- Heads-Heads-Heads-Tails -- each different person would attempt to guess the 5th flip using a different pattern that they saw. One might assume that we would now see three Tails flipped in a row to match our earlier run in Heads flips, or a different person might guess that we were bound to start a another run on Heads and make that rationalization for the 5th flip.
The correct answer, of course, is that you can't predict the next flip based on the recent pattern. Every coin flip is a 50/50 proposition independent of the previous flips. But it doesn't stop us from guessing.
Another brain issue that humans run into is Recency Bias, and it's also simple and easy to understand. Recency bias means that humans are inclined to make predictions on what will happen next based on what has happened to us most recently. Super helpful in dealing with mundane tasks like making the coffee in the morning or commuting to work, but horrible for helping us predict the behavior of stock and bond markets.
The point isn’t that you should have predicted the timing of the bubble or the upswing but that you should have considered both possibilities as potential outcomes and planned accordingly. Instead of taking the long view and considering as many factors as possible (the market goes up AND down), we settle into a rut and keep behaving as though nothing will ever get us out of it. ~ Carl Richards
FOMO...Not Just for Young People
Fear of Missing Out, or FOMO, is another great wonder of our intelligent, yet sometimes dimwitted, brain. Popularized in social media memes and a term coined in 2004, FOMO has a much longer history of causing distress for human beings.
One of the big issues with the amazing run in the stock market since the financial crisis of 2008 is that so many people missed out on it. Recency bias, unfortunately, had it's hand in terrifying both younger and older investors alike, causing some to delay investing in their 401k at work or others to swear off investing altogether. After witnessing brutal stock market losses in 2008, many were reluctant to come out of their caves and invest again. The massacre in the US stock market claimed even more victims during the recovery then it did on its way down.
It was often referred to as "the greatest bull market that everyone loves to hate". Until recently...when FOMO finally kicked into gear and money came flying in from every corner of the retail market place.
A Dash of Confirmation Bias
Of course, that leads me to present time. As if all these other nightmares haven't caused us enough harm, The Mother of All Biases (according to Tom Gilovich of Cornell University), Confirmation Bias, is about to rear it's ugly head with a few of you. Most notably, it will be those of you that listened to every Nervous Nelly on CNBC for the last 10 years giving yourself excuse after excuse to stay out of the market. And now that you finally came to your senses, you've been repaid with the worst week in 2 years.
This is how the insidious Confirmation Bias works, and how it feeds on most of its prey. It means that we are constantly on the lookout for reasons to confirm that we were right (or wrong) in the first place.
A week like this is the perfect fuel on the fire for anyone that just knew..."as soon as I put my money back to work, something horrible will happen. Watch."
Are We All Doomed for Investment Failure?
The short answer is no. There are ways you can plan and build a portfolio that is durable enough to withstand the big shocks. Most of that can be done through proper asset allocation and understanding what risks you should be taking versus the risks that don't help your portfolio.
While nothing is bullet proof, a financial plan with a portfolio tailored to your needs will certainly help weather the storm. What won't help, however, is thinking you can find someone that can time the market or just staying on the sidelines and giving up.
I also like to point to a chart that helps in times like this keep the appropriate perspective. HulbertRatings.com put this together to see if there was any predictive power in looking at how the stock market performed the previous year to what it would do in the coming year. They looked back at the Dow Industrial average since 1897.
Stocks typically go up. But they don't always go up. And you know what helps you predict when they will go up (or down) again? Not much. The chart above shows the probability that the stock market will be up in all the years (roughly 2/3 of the time), how it performs the year after it was up (up roughly 2/3 of the time), how it performs the year after it was down (up roughly 2/3 of the time), and how it performs the year after it's up big, or over 20% (up roughly 2/3 of the time).
I hope you detected a pattern there. I think this one is actually pretty helpful.
Additional Reading and Sources
Tomorrow’s Market Probably Won’t Look Anything Like Today - by Carl Richards, New York Times
Humans Are the World's Best Pattern-Recognition Machines, But for How Long? - by Dominic Basulto, BigThink.com
Dr. Thomas D. Gilovich Talks About Human Behavior - Masters in Business with Barry Ritholtz
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