Wednesday, 3 April 2019

No One is Immune from The Party Effect or Recency Bias

What is the Recency Bias?

When describing the stock market each participant sees their portfolio’s performance 
  • from their perspective only and 
  • thus they are always “right”.
This leads to what I call The Party Effect or what Financial Behaviorist call the Recency Bias.

An illustration

Historical average rate of return is 12%.  What does this imply? Would everyone have the same rate of return?

Imagine that you attended a party hosted by your investment advisor and that in addition to you, also in attendance were several other clients. As you go around the room and meet people you learn that everyone at the party owns the exact same S&P 500 index mutual fund. I use the S&P 500 for this tale because by many measures it has historically produce an average rate of return of about 12% and as many people know, and now you know as well, it represents what many investors call “the stock market.” 

The question then is would everyone have the same rate of return at this party? 
  • Of course the answer is, no they would not. 
  • If they started at the same time they would but since people invest or come into the life of the investment advisor at different times, the answer is no.

A party with only 30 guests, specially selected for illustration.

Let’s tighten up the party attendee list and invite only 30 guests. For simplicity, let’s assume that Guest 1 purchased the fund 30 months ago, that Guest 2 purchased it 29 months ago, that Guest 3 purchased it 28 months ago, etc. 

What would the guests discuss? What would be their perspectives of the stock market?  In order to determine what the guests would discuss and how they would evaluate their performance we need to have some data in the form of monthly rates of return. So we need to develop a monthly rate of return for 30 months to see what they see. 

A 30-month cycle: 18 months bull market phase and 12 months bear market phase 

Again, for simplicity, assume that for the first 18 months the fund goes up 3% per month and for the next 12 months it goes down 2% per month. 

  • Please note that I didn’t pick this sequence of numbers randomly. I have a purpose to this. 
  • This particular sequence approximates how the stock market moves in terms of bull and bear market duration and after 30 months returns approximately 12%; 12.28% to be exact. 
  • This sequence of numbers is a good sequence to illustrate The Party Effect or Recency Bias. 
  • We can characterize the first 18 months as the bull market phase of the 30-month cycle and the last 12 months as the bear market phase of the 30-month cycle.

Focus on 4 guests (1, 10, 19 and 25) to illustrate the Party Effect

To illustrate The Party Effect lets focus on 4 guests and see how they describe the stock market. Let’s look at guests 1, 10, 19 and 25. I picked these 4 because readers of this tale can relate in some form or another to one of these 4.

  • Guest 1 started 30 months ago, at the beginning of the bull market phase, and his rate of return is 12.28% for the entire 30-month cycle. He enjoyed the ride up for 18 months and now the ride down for the last 12.
  • Guest 10 started 21 months ago, halfway through the bull market phase, and his rate of return is 1.36%  for the 21-month period he has been invested.
  • Guest 19 started 12 months ago, at the beginning of the bear market phase, and his rate of return is  -21.53% for the 12-month period he has been invested.
  • Finally, Guest 25 started 6 months ago, halfway through the bear market phase, and his rate of return is  –11.42 for the 6-month period he has been invested.
These 4 guests experienced entirely different rate of return outcomes and view their portfolios and thus the stock market completely different. 
  • All 4 are correct. 
  • All 4 are right and yet they couldn’t possibly have more divergent outcomes. 
  • If they don’t have a complete picture of the stock market, they can get themselves in trouble. 
  • The difference between the best performing portfolio that is up 12.28% and the worst performing portfolio that is down 21.53% is an astounding 33.81%. 

Stock market investing will always produce different outcomes

Is this too obvious? You may say, of course they have different outcomes, they started at different times but that is not the point.  The point is that stock market investing will always produce different outcomes. 

  • One guest started at the worst time possible. 
  • Another guest started at the best possible time. 
  • How they look at the past determines how they see the present. 
  • Most importantly, it will determine how they will act going forward.

Pitfalls and dangers of the Party Effect or Recency Bias

The Party Effect simply states that stock market participants evaluate their portfolio performance based on their perspective and their perspective only. 

They do not see the market as it is but as they are. 

Without an expert understanding of how the stock market works, this leads to incorrect conclusions that ultimately lead to incorrect decisions. 

The field of Behavioral Finance (BF) has shown time and time again that people have variable risk profiles. BF demonstrates that fear is a stronger emotion than greed. 
  • This means that in our simple 4 guest example, Guests 3 and 4 are more likely to exit the stock market at just the wrong time since their recent, thus Recency Bias, experience is one of losing money. 
  • It means that Guest 1 and 2 are more likely to stay invested, thus catching the next wave up that is likely to follow. 

No one is immune to the Party Effect or Recency Bias

All 4 have intellectual access to the events of the last 30 months.  All 4 can educate themselves on the stock market. 
  • However, their particular situation is so biased by recent events that the facts are unimportant. They behave irrationally. 
  • I have witnessed this irrational behavior throughout my career. 
  • No one is immune, even advisors.

To overcome:  be an expert on the stock market yourself.

There are ways to combat The Party Effect trap but it is the deadliest of all the stock market traps that I know. Few can overcome it.  

The only sure way to overcome it is to
  • become an expert on the stock market yourself, 
  • learn to manage your emotions, and 
  • then either manage your own money or hire competent managers that you recognize are expert in their chosen investment discipline. 

However, if you hire an expert on the stock market you have not solved the problem if you do not have expertise. Let me repeat this sentence and highlight it. If you hire an expert on the stock market you have not solved The Party Effect trap if you do not have expertise yourself. 

When you hire an expert on the stock market without being an expert yourself all you have done is added complexity to a complex problem. 
  • You have inserted another variable between you and the stock market. 
  • You now have three variables to worry about, the stock market, your advisor and yourself. 
Without expertise you have no way of knowing if your advisor is an expert. You are in an endless loop. 
  • You are in a recursive situation. Just like we ask, what came first the chicken or the egg? 
  • The Party Effect asks, how do I hire an expert without being an expert myself?

If you are unwilling to become an expert on the stock market you must find a way to solve The Party Effect trap? 


MMF Solutions said...

Very interesting indeed. The party effect trap is something new for me to know. Thanks for sharing this info.

Anonymous said...

Couldn't agree more.