The Recency Effect & Investors

What do gold prices, a stock-market plunge and a credit crisis have in common? The way investors tend to see them are examples of the “recency effect.

A brief description first: In human psychology, people who are asked to recall items on a long list tend to have a sharper memory of the items toward the end. This is a function of finite memory capacity — you can’t remember everything, so you recall the more recent items.

From an evolutionary perspective, this makes some sense. Focusing on what happened some time ago while imminent threats exist probably isn’t the ideal survival strategy. The most recent threats are likely the more dangerous ones to your ability to procreate and pass on your DNA.

We see this manifest itself in investing in a related, albeit more nuanced way. Just to cite a few examples: Puerto Rico’s default is the new Greece; auto loans are the next subprime credit collapse; student debt is the next economic crisis.

All of these are demonstrably untrue (“So far!,” go the cries from the peanut gallery, where the recency effect is in full bloom). The issues resonate, because these events are a) recent and b) they traumatized many investors.

Trauma may be the key to understanding investment-related recency effects. In investing, it isn’t just the most recent events that stand out; it’s events of greater psychological or emotional weight that leave the more lasting mark.

Perhaps this emotional component is why so many people tend to make grotesque exaggerations and extrapolate in ways that lead to some truly awful forecasts. The credit crisis of 2008-09 means another, bigger market crash is just around the corner. The 41 percent drop in the value of the dollar from 2001 to 2008 means the end of the fiat currencies is nigh. Hyperinflation is coming! Buy gold!


Continues here: Confusing What Just Happened With What Happens Next




Category: Cognitive Foibles, Psychology, Trading

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Category: Books, Fixed Income/Interest Rates, Think Tank