The one great consistency of the stock market is change. There are endless cycles of ups and downs. Bull markets are followed by bear markets and vice versa. Recognizing when the cycles are shifting is difficult, and every market cycle is different in various ways, but therein lies the great challenge and opportunity of the market.
While the cycles of ups and downs are very obvious in theory, many market players have a hard time recognizing the shift in cycles as they actually occur. While we all know that the current cycle will eventually end, there is a very strong inclination to believe that the current trend will continue. We are inclined to believe that what occurred most recently is going to happen again next week.
In behavioral economics, this tendency is known as ‘recency bias.’
Recency bias is defined as a cognitive tendency that favors recent events over historical events. We give greater weight to what we have experienced recently. If the market has been trending in one direction for a while, our general tendency is to believe that it will continue to trend in the same direction. Currently, there is extremely poor action in many small-cap stocks, and the general inclination is to believe that is going to continue. That feeling causes many market participant to think they should just give up as they are never going to make money again
The challenge of recency bias is that it often works in our favor. It helps to keep us with a strong market trend. Anyone that uses a trend-following approach to the market is aware that trends tend to persist longer than seems reasonable. A strong recency bias will help you stay with the trend rather than fight it. The problem is that recency bias also will push us to overstay our welcome. We will be reluctant to give up on what has worked so well for so long.
Recency bias only becomes a problem once the trend starts to deteriorate and the next market cycle starts to develop. We struggle to react to the change in conditions because we have had a good run and are blinded by positive reinforcement. It is very hard to embrace a shift in market character.
The recent market provides a good example. Traders were in a frenzy as the trend of exceptional stock picking that began in mid-2020 continued until mid-February. For a number of reasons, it came to an abrupt end, but recency bias drove many traders to believe it would quickly resume, but that hasn’t occurred. Instead, this has turned into a miserable trading environment for many of the stocks that were the big winners.
Recency bias is now working in the other direction. After two months of struggles, many traders can’t see the light at the end of the tunnel. They are convinced that the recent poor action will continue, and many will capitulate and throw in the towel. It is the mirror opposite of what occurred in mid-February when recency bias drove them to stay with the very strong positive momentum.
Recency bias is great when we are in tune with what is happening in the market, but it is a money loser when we are not in tune with the action and are not positioned correctly.
Something that goes hand-in-hand with cycles and recency bias is the Pareto Principle. The Pareto Principle is more commonly known as the 80-20 rule. The principle states that approximately 80% of the effect of something comes from 20% of the causes.
For example, in business, 80% of the revenue often comes from 20% of its customers. In economics, it has been observed that 80% of the wealth in the world is controlled by 20% of the people. There are numerous other examples of this rule in economics, business, and science.
Although traders often strive to produce steady profits regardless of market conditions, the reality is that they make little progress and even lose money 80% of the time. The big profits will occur in only 20% of the time that we are trading. The exact percentages here are unimportant. The important point is that the production of trading profits is likely to be very lumpy over time.
For most traders, the 20% of the time that they are generating their big profits occurs when they are fully in tune with the current market trends. They make the big bucks when they understand market character and themes and are trading them aggressively.
Eventually, the trend comes to an end, and that is when recency bias becomes a major problem, and we are then stuck with the downside of the Pareto Principle when we don’t make any progress for a while. We are struggling to get back in tune with the market action and trying to overcome recent biases that are no longer working. Shifting to be in tune with the market is a very hard task, and we spend the majority of our time trying to accomplish that task. The market is a difficult beast to understand at times and will do its best to mislead us.
The best way to deal with the issues of recency bias and the Pareto Principle is awareness. How are these two issues impacting your current view of the market? Is recency bias driving you to fight the current trend? Are you trying too hard to produce positive results in an environment that isn’t favoring them? Are you letting the recent trends make you too optimistic or pessimistic? Have you forgotten about the inevitability of the next market cycle?
Effective navigation of the cycles of the market is the key to success. If you recognize how recency bias and the Pareto Principle impact your emotions, then you will be in a better position to excel.