__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: 1____8 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. __

__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
between you and the stock market.**another variable** **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?

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