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A brief discussion of Recency Bias & Bandwagon Effect March 4, 2009

Posted by shaferfinancial in Finance.
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Cognitive biases are rarely discussed in polite company, but in reality effect everything we do.  No one is free from cognitive biases, and most aren’t even aware of its existence.  At least one main religion, Buddhism, is based on recognizing these personal biases and correcting for them.

I thought a quick exploration of two biases would be instructive into what is going on in the financial world.  Recency bias is the tendency to weigh recent events more than earlier events.  That manifests itself in the feeling that whatever is happening now will continue to happen into the future.  Thus we get folks who feel the financial markets will go down forever, because they are going down now or vice versa.  Hence the fact that most people tend to buy high and sell low instead of buying low and selling high!

The band wagon effect  is the observation that people often do and believe things because many other people do and believe the same things.  The bandwagon effect is well-documented in behavioral psychology and has many applications. The general rule is that conduct or beliefs spread among people, as fads clearly do, with “the probability of any individual adopting it increasing with the proportion who have already done so”.  As more people come to believe in something, others also “hop on the bandwagon” regardless of the underlying evidence. The tendency to follow the actions or beliefs of others can occur because individuals directly prefer to conform, or because individuals derive information from others. Both explanations have been used for evidence of conformity in psychological experiments.  As more and more people become pessimistic about the economy, an avalanche of folks hop on the bandwagon of pessimism.  Same works in reverse and causes the speculative bubbles of tech stocks and real estate we have seen of late.

The question of course is how do we know when these biases have overcome our rational judgement?  The truth is our ability to overcome any cognitive bias is determined by our willingness to explore those biases internally.  Unless we are willing to take on that project, we will be victim to our internal emotional biases. 

When it come to the market, any market, what Ben Graham discovered and Warren Buffett, George Soros, trend followers, etc. found was that you could benefit from others’ cognitive biases.  Hence you have trend followers making $Billions by shorting the market over the last year, and you have Warren Buffett putting his cash to work for him finally (He has been waiting since the early 2000s), and you have the majority running around in fear of the coming depression and/or telling us this time is different.  And you have the prophets of doom who many are now thinking can predict the future being followed by the herd!  If you ever wonder what happened to all those militia folks who were wondering the woods with weapons before Oklahoma City, simply go on any number of financial sites and see how they morphed from constitutional scholars to economist over the last decade!!

The market has lost 50% of its value since July.  Are profits down 50%?  Well no.  The P/E ratio of the S&P 500 has dropped down to almost 10 (operating earnings) from over 17.  Now I am not calling a market bottom, because of these two biases that investors are in the grips of could very well push down the market much more.  But one thing I will bet on is that sometime in the future these same biases will push the market up to speculative bubble marks and people will once more be in a buying frenzy forgetting that the market goes down as well as up!

At the Shafer Wealth Academy we work on our cognitive biases to the point we at least know we have them!  And we become better investors because of that work!

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Comments»

1. Find a good mortgage lender - January 9, 2014

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2. StevenJonKaplan - May 15, 2015

Looking back on May 15, 2015, it is clear that this was a very timely and relevant article indeed. Thank you!


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