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Weekend reading: Recency bias, standard deviation, and cumulative gains

Weekend reading: Recency bias, standard deviation, and cumulative gains post image

What caught my eye this week.

One of the most easily spotted and ever-repeated psychological errors we make is recency bias. This is the tendency to believe that what has happened lately will continue forever.

You see it all the time in comments here. To give just three examples:

  • In 2008 and 2009, loud commentators called me irresponsible for saying it was a good time to invest while markets were cheap and fearful. They urged other readers to keep their money in gold and/or under the mattress.
  • When emerging markets were doing well a few years ago while developed world shares were in the doldrums, putting any money to work in the US or (god forbid) Europe was considered the mad folly of an old fogey who had never heard of Samsung.
  • American friends told me to steer clear of US house builders because the upcoming millennial generation all liked renting and – apparently – living in their parents’ basements. I wanted to invest with a US friend directly into US property as that economy began to recover but he was gun shy. Now the US housing market is booming, and millennials want their own homes. (A similar story can be written in the UK – see my post on UK home builders from late 2011).

Of course, I can be as prone to recency bias as much as anyone. But by definition it’s easier to see it in other people.

Onwards, downwards, and upwards

Recessions are a great time for students of recency bias to pull up a stool, crack out a soda, and start taking notes.

People are invariably gloomy during recessions, and they’ve often lost money. Many are scared. Jobs go among family and friends, if not your own. Commentators lament that we’ll never again see a summer of easy access 0% credit cards, people quitting the office to day shares from their bedrooms, or exuberant articles about rampant retail spending illustrated with a young woman carrying five or six brightly coloured bags of cheap clothes down Oxford Street.

Yet things do bounce back. The economy does recover. Stock markets usually sniff it out sooner, and begin to climb 6-12 months in advance.

In the long-run (short of rare catastrophes) things aren’t so bad.

This is well illustrated by this pair of graphs highlighted this week by The Value Perspective:

Two graphs illustrating how short term volatility can translate into long-temr progress.

Short-term: Ups and downs. Long-term: Ski slope.

Source: The Value Perspective/Bloomberg.

Ready to have your mind blown? These two charts show the same thing:

One may look deeply volatile and scary and the other smooth and reassuring but they actually both represent the same information.

The chart at the top shows how US gross domestic product (GDP) numbers have bounced around since the end of the second world war while the chart on the bottom shows the cumulative effect of that – the actual nominal growth of the US economy in that time.

This is what I keep trying to explain to people about my views regarding Brexit. I expect volatility short-term – we’re already seeing that – and with respect to the second chart I expect our slope to be less steep than it would have been.

But we’ll still grow, eventually, over the long-term. It’s just we’ll probably have slower growth, and lower total output, and hence a lower standard of living and so less money to spend on the NHS and so forth than we would have. All for very little gain.

To tie this back to investing, here’s one of my all-time favourite graphics from Portfolio Charts.

Take a look at the graph and ask yourself which of the scenarios – represented by the three colored lines – would you prefer to have invested through?

Graph showing standard deviation of a set of returns sorted three different ways.

Which looks like the lease volatile ride to you?

Source: Portfolio Charts / Peter Martin.

Ready to have your mind blown, again? They all show the same returns!

To quote Portfolio Charts:

If you’re like me, the yellow portfolio intuitively seems to have the lowest volatility and the magenta option seems downright terrifying.

Well guess what — they all have the identical average return and standard deviation!

The blue series is taken from a real fund. The magenta series takes the exact same returns numbers and simply reorders them from worst to best while the yellow series juggles them to stay as flat as possible.

While the order of returns has a massive effect on the personal experience of the investor, it has no impact at all on the standard deviation calculations.

Please do ponder the first two graphs of US GDP and this third graph showing how sorting returns changes our perception of risk. This is brain food for investors.

Have a good weekend!

From Monevator

Quick Budget discussion from an investor’s point of view – Monevator and Comments

From the archive-ator: Become your money hero – Monevator

News

Note: Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber.1

Tax man’s new powers to raid salaries are hidden in the Budget – ThisIsMoney

First-time buyers using shared ownership risk missing stamp duty exemption – Telegraph

‘Patient capital’ plan could unlock pensions savings limits [Search result]FT

[For what it’s worth] OBR growth forecasts have been slashed – ThisIsMoney

Products and services

What happens when you invest in a tracker? A day at Vanguard’s office – Telegraph

Discount railcard extended for people up to age 30 – BBC

Buy-to-let lenders are relaxing lending standards – ThisIsMoney

How to tell if you’re a first-time buyer to qualify for stamp duty cut – Guardian

The UK’s hidden one-child-per-family university policy [Search result]FT

Meet the first-time buyers handed a Budget windfall – ThisIsMoney

ISA limit unchanged, but JISA and lifetime pension allowances up – CityWire

Hargreaves Lansdown now has one million customers – Hargreaves Lansdown

Comment and opinion

Retirement: It’s not about the money – Of Dollars and Data

An alternative, rational UK Budget – Fire V London

The fund industry’s brain drain – Morningstar

All the right reasons – Humble Dollar

Simon Lambert: All movers need help with stamp duty – ThisIsMoney

Early retirement: Easier said than done – 3652 Days

The charmed life of a thankful investor – Portfolio Charts

Congratulations! You’ve won the lottery! – The Escape Artist

Beware the illusory superiority of active funds – Invest with ETFs

When tail risk isn’t tail risk – Cullen Roche

Why fund management firms are promoting younger CEOs – Institutional Investor

Mr Money Mustache, Uber driver – Mr Money Mustache

Capital light compounders, with Connor Leonard [Podcast]Invest With The Best

Off our beat

The perils of crowdfunded innovation – David Bland via [Abnormal Returns]

The year of living dangerously – Josh Brown

A statistical analysis that explains the history of popular music – Quartzy

The financial realities of going viral – Lucy Bellwood

And finally…

“Planning for retirement involves taking an inventory of not only your finances, but also your skills, your health, your friends, your family, your marital status, your interests, and your dreams. You must design a retirement plan based on your personal situation, and then implement it to the best of your ability.”
– Ernie Zelinski, How to Retire Happy, Wild, and Free

Like these links? Subscribe to get them every Friday!

  1. Note some articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”. []

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{ 15 comments… add one }
  • 1 Mr Optimistic November 24, 2017, 5:43 pm

    Always look forward to this, so thanks. As an aside, I may have hallucinated this, but did I read somewhere that new regulations on banking protection were being introduced which allow retail depositors to be tapped if the bank needs to call on money? Perhaps someone could comment?

  • 2 The Rhino November 24, 2017, 6:15 pm

    As well as recency bias you don’t seem to suffer from confirmation bias or anchoring either.

    Lack of confirmation bias is evident as MV comments aren’t really much of an echo chamber. That’s largely down to how it’s curated.

    Lack of anchoring is evident by recent primary residence revelations. Everybody’s mind has been blown by that one 😉

  • 3 Adam November 24, 2017, 6:18 pm

    Re. The volatility graph with the 3 coloured lines. I can believe that the overall return from all 3 scenarios is the same if you invested a single lump sum at the starting point. (Is that the mind-blowing bit?) But if you invested continually throughout the time period then surely the magenta sorted curve gives the highest overall return – due to sequence of returns and all that. Is that correct, or have I missed something?

    (First time commenter, but long time reader. Thanks for the education – it would have been useful if they had explained stuff like this in school. Maybe the Monevator book should be a textbook?)

  • 4 William III November 24, 2017, 8:02 pm

    A nice early start of the weekend then. That Reformed Broker post is just brutal, brutal.. and apt.

  • 5 The Rhino November 25, 2017, 9:55 am

    MSW on maths (of BTL)

    Ahttps://www.ft.com/content/c6413d14-d06a-11e7-9dbb-291a884dd8c6

  • 6 Simon November 25, 2017, 10:50 am

    “But we’ll still grow, eventually, over the long-term. It’s just we’ll probably have slower growth, and lower total output, and hence a lower standard of living and so less money to spend on the NHS and so forth than we would have. All for very little gain.”

    Well summarised, economically. But for what gains? Less foreigners? I like having them around personally but that’s cultural. Either way, it seems there will be no reduction in numbers because we need them to run the economy. But no one told the self-styled “Brexiteers” that at the time. For more sovereignty? To me, handing more power to the stooges in Westminster looks a very bad idea.

  • 7 old_eyes November 25, 2017, 11:26 am

    I had the same reaction as @Adam. Surely sequence of returns risks plays a part here, and as always depends on where you are on the journey? So the personal experience of volatility and outcome would be different for different investors.

    That said, the core point of the biases human thinking is prone to is an important one and bears repeating often and loudly.

    As with many things, the trick is to be aware of your own weaknesses and to take steps to prevent yourself doing stupid things whilst in the grip of your various delusions.

  • 8 hosimpson November 25, 2017, 11:29 am

    Loved Josh Brown’s article. Yes, it pretty much sums it all up.

  • 9 Naeclue November 25, 2017, 12:24 pm

    @Adam, quite right. Overall return is the same, but for those adding and removing cash between the ends, the outcomes can be very different. Magenta is superb for regular savers, awful for those drawing down. Yellow is the best for drawdown.

  • 10 The Investor November 25, 2017, 12:29 pm

    @oldeyes @adam — The three lines deliver the same eventual return from start to end. They simply reorder the annual returns in different dramatic ways — but the order of returns makes no difference to final outcome! Sequence of returns risk applies if you are adding/withdrawing money. That is not the case here. (Apologies, staying with friends away so have to be brief!)

    Of course the three experiences will likely *feel* different, as you elude, which is why I introduced it here. Equally in some very real sense they differ in risk (because of the huge difference in drawdown wn route) even though end point is the same. (Which is what graphic originally intended to convey. 🙂 )

  • 11 The Investor November 25, 2017, 12:38 pm

    @Simon — Apologies, can’t remember if you’re a regular but if not then absolutely the ‘house views’ is those non-economic things are not gains, either. I am not for them. I’m solid metro-elite.

    However given very slightly more people voted Leave than not, then presumably they’ll be happier if we get then. Since there’s slightly more of those voters (or were, a big chunk will already be dead by now), then I think on a national perspective we’d have to allow the non-economic things are slight gains.

  • 12 Mr Optimistic November 25, 2017, 2:57 pm

    Don’t forget tribalism. Manifests in football support, religion, nationalism etc. Perhaps an evolutionary thing sourced from the same root as family. As the old saying goes in the Middle East, ‘Family before friends, friends before strangers, strangers before foreigners’. Another insidious source of bias 🙂

  • 13 AncientI November 25, 2017, 10:31 pm

    RE: home building companies

    would they not still be good investments given that the housing crisis is becoming more into focus in politics and for the fact we still have a crisis?

    when watching Question Time other night some guy in the audience complained about the massive amount of house building in colchester and the complete lack of infrastructure ( roads , hospitals etc ) to support it. So perhaps thats something else to think about.

  • 14 Neverland November 26, 2017, 9:06 am

    Not sure about all this “eventually the economy will grow stuff”

    Britain’s recent prosperity has rested a lot on north sea oil/gas and being the banking/ finance hub for the continent of Europe

    Both of those industries are now evidently not continuing much longer

    A brief look at countries like Argentina, Italy and Greece reveal what happens when countries make the wrong political choices

    If your economy shrinks and then goes up, you have “growth” but its still way smaller than it would have been had you continued on your long term growth path

  • 15 Mr Optimistic November 26, 2017, 10:32 am

    Growth? Not that I am a great thinker but two things worry me. The first is that the economic history over my lifetime, 60 years, has been based on recovery from WW2 and the plucking of low hanging technical advance which may be atypical. Perhaps a lot of the intergenerational angst is really caused by a shift in the underlying growth of productivity, not in the predations of a greedy previous generation. The past growth also fuelled large changes in now we in the west saw each other. The transistor and lasers were discovered before 1960, computing ditto and the 747 is a 1959’s concept. So is the concept of teenager. The world has opened up for investment in that era too. Now there are no more geographic areas left to be incorporated in to the market, or exploited for a transitional period. Could be argued that the USA and now China, have exploited the rest of the world by exporting their temporary productivity advantages.

    The other worry is that the persistence of low interest rates means there is too much capital, too much savings, relative to productive opportunities, perhaps linked to the above. In the past the world has found a way of destroying excess capital through railway booms, financial collapses, wars. How is it going to do it this time?

    Just been reading an interview with Morrissey in the paper. Hope it doesn’t show……..

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