November 30, 2006 – Here is the Wikipedia definition of the psychology phenomenon known as the recency effect: “A cognitive bias that results from disproportionate salience of recent stimuli or observations. For example, if a driver sees an equal total number of red cars as blue cars during a long journey, but there happens to be a glut of red cars at the end of the journey, he or she is likely to conclude that there were more red cars than blue cars throughout the drive.”
Obviously the cognitive bias created by the recency effect clouds sound judgment and decision making. In stock markets, the recency effect is particularly strong during good markets. People remember all their winning stocks and forget about all the losers. Or if losers have turned into winners, most investors feel that there’s no way that they could be bit again by the same correction bug. The recency effect, coupled with the horrible reporting of the financial media that often incorrectly reports on the true state of the economy, causes many investors to be blindsided when corrections occur. In our current global markets, the recency effect is firmly in play.
I would bet that for 99% of investors, the great pain that was induced by the large corrections in global markets just six months ago is now a very distant memory.
Everybody loves making money, so the cognitive bias in investment psychology, due to the relative robustness of current markets, is to disregard all indicators that signify a correction is coming, because such indicators dwell below the surface where they are not seen. Therefore, an irrational euphoria fuels their beliefs that the stock markets will go higher and higher. Currently, I see the most danger in the U.S. markets, but as we know, pullbacks in U.S. markets also trigger pullbacks in other major developed markets.
Even analysts are not immune to the recency effect. On Monday and Tuesday, when many of the leading global markets pulled back significantly only to recover slightly the next day, and then even more strongly yesterday, almost every analyst reported that the pullback on Monday and Tuesday was cause for no concern. If you have read any of my prior blog posts, you know that I highly disagree with this sentiment. I’ve already discussed many of the factors that drive my beliefs, so I’m not going to discuss them again here.
In fact, I even mentioned in a prior blog post the investment that offers the best risk-reward setup to hedge against the rosy outlook of the sheep herd when so much instability lurks underneath (specifically with the U.S. markets). At certain points and time, there are many different factors that converge and diverge to control global markets. Again, it’s truly difficult to predict if all the negative factors that lurk below the surface will impact markets starting tomorrow or a month for now. With the proper type of insurance, small rises in the markets won’t hurt you hardly at all, yet being a little early to the game as opposed to being a little late is of significant benefit.
When Central Banks raise interest rates, there is always a lag before higher interest rates are absorbed by the economy, sometimes requiring a full quarter or two for the effects to come to the forefront. The same applies to when Central Banks lower interest rates. People expect economies to immediately show improvement, but the fact is that it takes several months for such policies to be absorbed by economies.
The same is true of stock markets. While all is nice and rosy on the surface, factors that will cause markets to turn have been churning for months below the surface. That’s why when sudden drops occur, for many people, these drops are as surprising as a sudden storm that forms out of a clear blue sky with not a single cloud in sight. However,just as there are significant air temperature differences between atmospheric layers that creates the storm that are not visible to the naked eye, a similar scenario plagues stock markets. The only difference is that the conditions that whip up storms in stock markets are visible with a little digging. If investors keep their ears closer to the ground, they will be able to hear the sound of an uncoming stampede in the U.S. markets.
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J.S. Kim is the founder and Managing Director of maalamalama, a comprehensive online investment course that uses novel, proprietary advanced wealth planning techniques and the long tail of investing to identify low-risk, high-reward investment opportunities that seek to yield 25% or greater annual returns.
