Resist the Temptation to React to Financial Headlines

You’re looking for a new home, and you’ve found the perfect place — complete with a backyard swimming pool.

If you buy that house during the summer, you’re likely to pay $1,600 more than if you purchase it during the winter.

That’s according to a study by the University of California’s Riverside School of Business Administration. Researchers also found that car dealers sell 8.5 percent more convertibles when there’s a 20-degree rise in temperature and that sales of four-wheel-drive vehicles rise 6 percent after big snowfalls.

This study demonstrates the behavioral finance phenomenon called recency bias. It’s why we tend to buy a generator after a power blackout and umbrellas after a big rainstorm.

Just as recency bias can cause you to overpay for a house, it can cause you to make bad investment buy-sell decisions.

To illustrate, let’s look back to Feb. 5, 2018. On that day, the Dow fell 1,175 points — 4.6 percent of its value, the biggest one-day point drop in history.

Seeing a big, sudden decline undoubtedly spurred some investors to sell their stocks and stock funds and move that money to cash — a classic case of recency bias. Instead of considering long-term performance data, these people focused solely on the recent past, and, panicking over the losses of the past month, they sold.

These investors failed to remember that what matters is not what the market did in the last day, week, month or even year, but what it is likely to do in the future — and not just the coming day, week, month or even year, but the next few decades.

After all, if you’re investing for your lifetime, then let’s look out across all those years. And if you have only a few years — for example, if you know you’ll spend the money in just two or three years (say, to pay for college) — then you shouldn’t have that money in the stock market in the first place.

If your time horizon is long, you should recall long-term performance data. Since 1926, the stock market has produced a 10 percent average annual return, according to Ibbotson Associates. But this statistic doesn’t mollify some people. They fear that the market might suffer another “correction” (defined as a 10 percent drop in value) or even become a “bear market” (a drop of 20 percent).

Well, we can say with absolute certainty that there will be another market correction in the future. And it is virtually guaranteed that there will be a bear market decline of 20 percent someday.

No one knows when, of course. But we do know what will happen after the correction and bear market: Prices will rise.

So, the real question is not whether there will be a drop in the market or what will happen afterward. The real question is, when will declines occur? Knowing the answer would enable us to sell before the decline started and buy when prices were at the bottom.

Unfortunately, nobody knows when these events will occur. And guessing is highly unlikely to result in your doing the right thing at exactly the right time. You see, that’s the catch: It’s not enough to be right; you must be right at the right time.

Think about it: The Dow is currently hovering around 25,000. Say you predict that the Dow will fall 10 percent next week, to 22,500. So, you sell, figuring you’ll wait for the drop to occur and then buy back in at the low.

But what if you’re only half right?

What if the Dow rises to 29,000 before it suffers the 10 percent drop you’ve predicted? The decline would cut the Dow to 26,100 — roughly a thousand points higher than its current level.

In that scenario, ignoring your prediction would be more profitable than acting on it — even though you were right about that 10 percent correction. And if you actually had sold at 25,000, you would then have to buy back in at 26,100, causing you to suffer twice for this bad guess. Ugh.

That is why you must resist the temptation to react to current headlines or recent statements. Stay focused on your goals and let the markets do the rest.

Don’t become a victim of recency bias.

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