Happy New Year everyone. Cullen Roche of Pragmatic Capitalism wrote a thought provoking post regarding investors Biggest Risk in 2014. He writes …
The biggest risk in 2014 is likely to be a common one – recency bias. Otherwise known as your own brain’s tendency to focus excessively on things that have only just occurred. Of course, the markets don’t really care much for what’s just occurred. Most market participants are trying to make decisions based on what they think will occur in the future. Unfortunately, they often come to these conclusions based on extrapolating the recent past into the future. This is one of the broader causes of the herd effect and groupthink. It also contributes to market bubbles.
After a year like 2013 where many markets felt like a “can’t lose” proposition the tendency will be for many people to extrapolate the recent past into the future. They’ll deviate from their plans, reallocate a bit more aggressively or less aggressively and begin to fall in-line with the herd. But this is generally a bad idea. Letting the recent market action excessively influence your long-term plan is what I refer to as part of the multi-temporal problem in portfolio construction. And when you let your process become dictated by your emotions you generally lose control of your process and your portfolio plan begins to come unraveled.
So beware the recency bias in 2014.
He brings up a really important issue that all investors face. I would add this bias is alive and well not only this year but all other years for that matter (remember back what you were thinking what would happen in the markets after the 2008 crash). So while ridding yourself of this bias and all biases for that matter make for much better investment decisions, I feel the greatest risk to 2014 is something much different and I will cover that in its full glory next week.