The Market Doesn't Care What Price You Paid
Recency bias – that is, the tendency to overweight recent events – is a pernicious cognitive bias when investing. Being mindful of the effects of recency bias is the first step to enabling better decision making in the stock market, particularly during periods of heightened volatility.
I recently read Thinking in Bets, an insightful book by Annie Duke about decision making under uncertainty that is highly relevant to investors. Amongst the many nuggets of wisdom in the book was a section devoted to cognitive flaws that may distort our decision making. The discussion around recency bias and the effect it has on our emotions jumped out at me.
Consider the following example. In the first scenario, you purchase a stock for $100 and in the first month it appreciates to $150. However, over the course of the remainder of the year the stock falls back down to $100, erasing the prior profit. In the second scenario, a stock is purchased for $100 but subsequently falls to $50 in the first month. It then retraces its loss and ends back at $100. Both instances end with precisely the same outcome, so our emotional response should be the same, right?
Wrong. Those that purchased the stock and saw it rise to $150 would have first experienced elation, and then subsequently despair as the gains evaporated. This is known as loss aversion (first identified by Amos Tversky and Daniel Kahneman), and studies have suggested that we feel the pain from a loss twice as acutely as we feel the pleasure from a gain. On the other hand, those that bought the stock that plunged to $50 and then recovered would be feeling pretty good. The initial discomfort from the loss would be a distant memory by the end of the year, with our brains weighting the recent gain with more prominence.
Taking this example further, we can consider a situation where the stock that initially goes to $150 instead declines to $110; and the stock that hits $50 goes back up to only $90. Logically you would choose the situation that results in $110, but our emotional responses are probably incongruent with this. We are anchored to the initial 50 per cent gain, and even though we end up $20 ahead compared to the $90 payoff, emotionally we feel worse off and like we’ve lost.
This is a perverse situation whereby you actually feel better in the lower paying scenario. Our decision making is tainted by recency bias, where we overemphasise the most recent set of facts (in this case the gain from $50 to $90). This is very dangerous in investing and essentially zero attention should be paid to the path a stock has taken to get to the current share price. The market simply does not care if you bought a stock at $10, $20, or $100, or whether you’re currently sitting on a gain or loss.
A useful exercise is to ask yourself: would I buy this stock today at the current price? If your answer is no, then it is likely that you are making an emotional investment, and may be tethered to the recent set of events that led to the current share price.
One tenet offered by the book is to fast forward to your future self. The emotional impact from either outcome is attenuated the further forward in time you go. By being cognisant of our own emotional shortcomings, we can strive towards becoming better decision makers, and better investors.
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