The effects of psychological biases have a big influence on the way we invest. As Foolish investors, we need to take note of a few pertinent ones as the impact of our biases could turn out to be too costly to ignore. One such bias would be something called recency bias. This was covered in Jason Zweig’s book “Your Money and Your Brain”. Mr. Zweig is an award winning financial columnist for the Wall Street Journal. In his book, psychologists described this bias as: “… the human tendency to estimate probabilities not on the basis of long-term experience but…
The effects of psychological biases have a big influence on the way we invest. As Foolish investors, we need to take note of a few pertinent ones as the impact of our biases could turn out to be too costly to ignore.
One such bias would be something called recency bias. This was covered in Jason Zweig’s book “Your Money and Your Brain”. Mr. Zweig is an award winning financial columnist for the Wall Street Journal. In his book, psychologists described this bias as:
“… the human tendency to estimate probabilities not on the basis of long-term experience but rather on a handful of the latest outcomes”
Said differently, it means that individual investors may sometimes fall prey to placing more importance on recent events, and in the process, ignore the longer term track record of a company.
But, how does recency bias cost us when it comes to investing?
A short story of Wall Street and Wal-Mart
One notable example came a story from the Sam Walton’s (the founder of Wal-Mart Stores, Inc (NASDAQ: WMT).) book Made in America. Wal-Mart is the largest retailer in the America, and makes close to US$480 billion in revenue.
In his story, the founder recounted on how he struggled in his first attempt in management succession. Mr. Walton decided to step back from his role of Chief Executive Officer (CEO), and elect Ron Mayer to be the CEO of Wal-Mart. His maiden attempt would ultimately come to naught, as two competing factions began to appear within his own company. The drama all ended on a fateful Saturday in June 1976 when Mr. Walton decided that he needed to step back into the role of CEO to take control once again. Mr. Mayer left as a result, and the incident cost the company one third of its senior management team. It remains the event which is the least comfortable for the founder to talk about. He quipped:
“In company lore, that incident became known as the “Saturday Night Massacre”. You can imagine what Wall Street felt about that. A lot of folks wrote us off immediately. They thought, as they have through the years, that we just didn’t have the management to hold it together.
… they just ignored all the basics we had in place, all our principles: keeping our costs down, teaching our associates to take care of our customers, and frankly, working our tails off”
The cost of recency bias
In this case, it would seem like the Wall Street folks back then who wrote off Wal-Mart would have given too much weightage on recent events (“Saturday Night Massacre”), and in the process, forgotten the longer term track record (“low costs, taking care of customers”) that Wal-Mart had built up till then.
Ultimately, individual investors who sold Walmart would have made a costly error, as the share price of the American retailer would go on to rise by more than 2,200 times from 1 June 1976 up until last week.
At the local front, there was a similar scenario for massage chair maker OSIM International Ltd. (SGX:O23) back in 2008. Shares of the company sank to a price of $0.07 on 2 Jan 2009 as the company struggled with a failed acquisition. Individual investors who may have been too fixated on the failure, might have missed that OSIM was in fact free-cash-flow positive in 2008 ($14 million), and had a positive cash position ($26.3 million). OSIM went on to clock in 33 times in returns from 2 Jan 2009 on share price alone.
Foolish take away
As long term Foolish investors, our greatest advantage is in learning about a company over time. It could be helpful to keep a journal on what you have learnt about a company so far. In times of short term duress, this document — in which we list down the company’s strengths built up over the its lifetime — could come in handy as it would help remind us of why we bought the company in the first place.
By doing this, Foolish investors might be able to start pushing back on the effect of recency bias, and gain an advantage over the market. Learn more about investing and sign up now for a FREE subscription to The Motley Fool’s weekly investing newsletter Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.
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