My kids keep growing up, and it continues to surprise me. One who was just learning to stay upright is now a constant chatterbox and a daredevil on her Strider bike. The other seems to have grown a foot this year and has gone from quiet and reserved to confident ringleader of her friends.
But the realization I’ve recently had is that it is so easy for us to assume the current state of affairs will perpetuate into the future. The little baby who was so happy to sit and play with a toy was suddenly gone, whether I was prepared for it or not. Someday soon both of my girls will be in high school fighting over clothes and car keys. In the moment, that is hard to remember. Whether things are great and everyone in the house is sleeping and happy and playing nicely together or we’re up four times a night and separating a fight every twenty minutes, it is easy to believe that this is how things will always be.
In behavioral finance this effect is known as recency bias. It is our strong tendency to extrapolate recent events forward into the future. And investors do this all the time. I mean all the time.
In March 2009 as the stock market was approaching generational lows, the most popular headlines and predictions were that the Dow Jones Industrial Average, having just passed below 7000, would continue to drop as low as 3000. And of course the most famous example of receny bias is the book Dow 36,000. Published near the height of the stock market in 1999 when the DJIA was just above 11,000, the book was wildly wrong. But it was a perfect example of how easy it is for us to see a pattern and project it into the future.
We haven’t learned much since the 2008-2009 bear market or the late 90’s tech bubble. Oil prices seem to been in a near freefall for the past few years. So guess what is being predicted? More declines!
Goldman Sachs suggested that oil prices could go to $20 a barrel in September. Of course, in 2008 Goldman also predicted prices, then over $140 a barrel, would eventually surpass $200 a barrel. Making professional predictions is fairly easy, you take the recent changes and extrapolate them into the future. Tada!
And of course it isn’t just professionals making outlandish predictions that fall prey to recency issues. Individual investors are just as bad. Emerging markets have been dismal for the past several years. Returns have been negative so far in 2015 and Emerging Markets stocks lost money in 3 of the last 4 calendar years.
In May 2015 EM stocks started a nasty slide. By September, investors assuming that the recent past would continue indefinitely had had enough and started pulling money out of these funds. Here’s what flows out of Vanguard’s Emerging Markets ETF looked like this year.
Investors love to hear and talk about what is going on in the market “right now.” We love this idea because we assume that “right now” will continue into the future. But what is true today won’t necessarily be true tomorrow. The world is a changing place and always has been. Don’t be fooled thinking anything else.