Quote of the Week
“You should invest more when the tickets in the bowl are in your favor. You should invest less when they are against your favor and what determines the mix of the tickets in the bowl largely where we stand in the cycle.” – Howard Marks, Oaktree Capital and author of Mastering the Market Cycles
In a holiday-shortened week, stocks extended their recent gains getting back to where they were on April 1st. The markets just can’t seem to “get over the hump”. I suspect that investors are worried about a ton of bad news that is starting to come into play relating to a decline in economic growth in the U.S. and around the rest of the world. The investor psychology now is that the markets can only go up. Most investors don’t recognize the underlying facts. I suggest you read “Larry’s Thoughts” in this letter on recency and outcome biases.
Investors breathed a sigh of relief after the U.S. and China agreed to suspend new tariffs and resume negotiations. Even though that was the expected outcome, avoiding further escalation of trade tensions and moving further away from the worst-case scenario was still perceived as a positive. My personal suspicion is that the China is “slow playing Mr. Trump” until the election in hopes that he won’t be re-elected. We shall see what happens. I hope that Mr. Trump doesn’t do a bad deal just to get a deal.
Job growth last month refreshed economic optimism. Last week’s employment report shows that the U.S. economy added 224,000 new jobs in June, the strongest month since January and solidly above the 161,000 average so far in 2019. One month does not make a trend, but June’s strong jobs gains was a welcome rebound from the 72,000 jobs gains in May.
Behavioral Finance 101: Cognitive Biases
Markets are supposed to be rational. But people are anything but. That brings me to the subject of cognitive bias.
Investing, which on the surface seems very scientific, is actually a study in psychology as well.
Cognitive biases are errors in the way we think that influence how we make decisions. There are over 20 defined biases. But I want to talk about two, in particular, today: recency bias and outcome bias. The two go hand in hand. And they’re common biases seen in how people choose to invest.
Recency bias is exactly what it sounds like. People are more likely to believe that new information is better information. And they will base decisions on that instead of looking at the long term.
Think back to 2009. The market had suffered a massive decline of 57% over the period of 2008 and through April of 2009. And people were scared that was going to continue. So, many people pulled their investments. They were convinced that because things had been so bad recently, things could never get better ever again.
But as we all know, the stock market started to rally in April and actually finished 2009 with a double-digit gain.
Outcome bias is similar to recency bias and often works with its counterpart to get investors to make bad decisions. Outcome bias is simply when we look at an outcome and ignore the process that led to that event.
A good example is cryptocurrencies. They were on a ridiculous run up in 2017. Investors just looked at the outcome folks were bragging about: massive profits.
Nobody cared to investigate the process that led to those massive profits. Recency bias combined with outcome bias sent investors flocking to the cryptocurrencies just in time for the crash. The process for the outcome was an over-hyped bubble. Nobody took the time to do any analysis of historical average returns.
Those are just two examples of how recency and outcome bias can royally mess you over when it comes to money.
It took me a long time to come to the realization that behavioral biases are a terrible way to make investment decisions. We are all influenced by our emotions when it comes to money. That is why we use mathematical algorithms to make our investment decisions for you. We firmly believe that a mathematical process is the best strategy in the long run. Hope is not a successful investment strategy.
By the Numbers
GOING, GOING, GONE – 7,037 American retail stores have closed YTD through 6/30/19, already exceeding the 5,864 closures that occurred during all of calendar year 2018. This year’s store closures are on pace to exceed the all-time record of 8,139 from 2017 (source: Coresight Research). Michael A. Higley, BTN 07-07-2019
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These are the opinions of Larry Lof and Stephanie Mayoral and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Past performance is not indicative of future results. Due to our compliance review process, delayed dissemination of this commentary occurs.
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