Quote of the Week
“Most people do not see their beliefs. Instead, their beliefs tell them what to see. This is the simple difference between clarity and confusion.” – Matt Kahn
Stocks dipped for the second straight week. The S&P 500 dropped -0.57%. The other market indexes also followed suit being down between -0.07% for the Dow and -0.65% for the MSCI-EAFE. The Fed meets this week to determine whether to start to take away the “punch bowl” by slowing the purchases of government bonds this year or wait until next year.
On Monday of this week, we experienced another “episodic and non-trending volatility spike” with the Dow down over 600 points. Notice that I said “non-trending.” We don’t see an impending collapse in the markets. Quite the contrary, as the mathematics are trending towards the economy moving back into Quad II where the stock market rises and commodities also rise. The results are not in yet, so let’s keep hope alive. The underlying trend currently is in the right direction.
Consumer demand remains strong. Retail sales jumped a surprising +0.7%. Economists expected retail sales to drop by -0.7%. Demand moved from in-person to online. Sales would have grown even more if motor vehicles and parts hadn’t dropped -3.6% from the previous month. The drop is due primarily to the shortage of chips that go into new cars.
When the Federal Reserve meets this week, its members will face a difficult decision on whether to start reducing the purchase of bonds this year or continue to support the economy at current levels. The Fed currently buys $120 billion of government backed bonds each month made up of $80 billion in Treasury debt and $40 billion in mortgage-backed securities. The goal of the purchases is to push long-term interest rates lower, making it cheaper for corporations and homebuyers to borrow money or refinance loans. The weak jobs report two weeks ago raised some uncertainty about whether the economy was strong enough to warrant removing some of the support.
After Monday’s big drop in the markets, I received some calls wondering whether we are looking down the throat of a coming Armageddon. Fortunately, as of today (Wednesday), the markets have rallied back up above the opening on Monday, so Armageddon has been postponed for now. Of course, I am just kidding. These “episodic and non-trending volatility spikes” can send us all into a panic mode.
Larry’s Thoughts today is a reprint from our letter dated July 8, 2019. There are two investment biases errors that can affect how we look at our investment portfolios. I hope you will take a look so when another Monday happens you will be prepared emotionally.
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.
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