At its core, fundamental-based investing is an intellectual exercise. It involves performing research and analyzing financial and environmental data about companies and the industries in which they participate. But, we are only human, and there are many behavioral biases that can cloud our views. One example is recency bias, or the tendency of stock market participants to evaluate their portfolio’s performance based on recent results or on their perspectives of recent results.
So far in 2014, the market has been much more volatile than it was in 2013. When prices move lower on consecutive days, fears that the market will continue to push lower grow. At the same time, when the market turns upward, investors become more optimistic. In truth, it is impossible to accurately forecast the market’s short-term direction.
Investors often get caught up in the market’s daily ups and downs. Recent performance becomes a baseline for what they expect to happen in the future. When we are in a bull market, it becomes easy to forget that the market can go down. There is a tendency to think the market will keep going up, so we keep buying while ignoring the potential downside risks. This behavioral pattern has the perverse effect of increasing the inherent risk in portfolios, and all too often leads to panic-selling when the market reverses course. When the market is falling, we can become convinced that it will never go up again, so we want to liquidate our portfolios and stick the money under a mattress. Recency bias tells us the market is not going back up. Of course, one day it will, and before investors realize it, they have missed a big portion of the upswing.
The point is not that you should be able to predict the bubble, or the end of a bear market. It is important to consider both possibilities as potential outcomes and plan accordingly. Rather than take a long-term perspective and consider as many factors as possible (the market goes up AND down), individuals often take the easier path and focus primarily what is happening today.
At BWFA, we have an investment process that we use to select securities for inclusion in client portfolios. We also use specific criteria to help us determine when it is time to sell a stock. The combination of our investment process and our long-term approach to security selection helps us to better navigate through the market’s daily ups and downs. It also helps to minimize the impact that behavioral biases may have on performance.