The stock market this year reminds me of one of Rorschach’s inkblot tests. Year-to-date, U.S. stocks have gained nearly 10 percent, but it’s very difficult to know what to make of it. Bulls point to this year’s tax cuts and believe that the market makes complete sense. Bears, on the other hand, point to the fact that the market has quadrupled in less than ten years and conclude that it’s at an unsustainably high level. It’s very much in the eye of the beholder.
At times like this, we can be susceptible to biases in how we think about things, and that can impact how we respond. Below are three common investor biases along with some recommendations on how to manage them:
The Availability Bias: The Internet today gives us access to thousands of economic statistics and market indicators. No one, however — including full-time investors — has the time to sift through all this data. As a result, we tend to rely on the information that is most readily available or that comes to mind most easily. While the information might be correct, the danger is that it might be incomplete. Just this morning, for example, when the government announced that unemployment had hit a multi-decade low, the New York Times reported, “The current economic expansion is already one of the longest on record, and there is no sign that it is losing steam.” CNN put it in these enthusiastic terms: “The last time the roaring American jobs market was this strong, astronauts were still going to the moon.” Also today, however, the Tampa Bay Times ran an article titled, “As corporate debt rises, so do worries about it triggering the next recession,” and cautioned that, “By some measures, companies have more debt than at any time in history…” Depending upon which of these stories happened to cross your desk, you might reach very different conclusions about the health of the economy. That is the Availability Bias.
Confirmation Bias: A close cousin of the Availability Bias, Confirmation Bias occurs when you already have a point of view on an issue and then place disproportionate weight on data that supports that existing view, while downplaying data that does not support it. Today, for example, market bulls would point to record high corporate profits, while bears would point to a market valuation that is, by some measures, at a near-record level. Both facts are accurate, but the Confirmation Bias would enable people on both sides of this question to each reinforce their views.
Recency Bias: In New York today it is 70 degrees. If I asked you to forecast tomorrow’s weather, you would probably make a guess somewhere in the neighborhood of 70 degrees, and that would probably end up being about right. In many realms, it makes sense to extrapolate from recent data, to assume that current trends will continue. When it comes to the economy and the stock market, however, that unfortunately does not work. There’s an old joke, in fact, that economists have predicted fifteen of the last ten recessions. This rings true because, despite people’s best efforts, no one can reliably predict when the next bump in the road will come or what it will look like.
Investing, I believe, requires a constant balancing act. Yes, you want to be aware of where the economy stands and what the market is doing, but you also want to work hard to avoid letting biases like this cloud your view. And, you also want to keep in mind that ultimately all of the data in the world still present a picture that is incomplete. As the investor and author Howard Marks points out, “much of risk is subjective, hidden and unquantifiable.” For that reason, I believe that the most productive step you can take at this point, while the market is still strong, is to check and re-check your asset allocation. Even if you have a view on the way things will turn out, be sure that you’ll be okay even if it happens to go the other way.