If there’s one great certainty about the market, it’s that there will always be cycles. Bear markets are an essential part of a healthy market, as they create the next opportunities for wealth creation in the next bull market that will inevitably follow. Active investors understand the fact that these cycles exist, but it’s always a challenge to identify inflection points as they occur. We all know that whatever phase of the cycle we may currently be in will eventually end, it’s often a struggle to envision action that is different than what we’re currently experiencing. It feels like we’ll never see another down day in a market that can’t seem to do anything but go up, and it definitely feels like we’ll never see an uptrend again in the belly of a bear market.
In the field of behavioral finance, that tendency that we all have to give extra weight to our most recent experiences when making decisions is called recency bias. It’s what tempts us to chase a hot stock, stay away from a sector that has been taking a beating, think that the downward pressure in a bear market will never end, or wonder if that cryptocurrency that started as a joke may, after all, make it to the moon!
Of course, recency bias can be both a blessing and a curse. On the one hand, the trend truly is your friend. How we manage positions in a bull market is vastly different than how we manage positions in a bear market. Sticking with the appropriate approach in any given market phase is tantamount to both our short- and long-term success, as is understanding the fact that trends tend to last far longer than will ever seem reasonable. It keeps us pressing when the pricing action is favorable and defensive when it’s not.
The bad news is that investors can also be slow on the uptake when conditions really have begun to change. We saw that in the tops that occurred in 2000, 2008, and in 2022. Although conditions were rapidly changing and various areas of the market had already broken down badly, the major indices continued to hit fresh highs, as investors kept buying a narrowing group of popular, mega-cap names. And in 2009, when the market finally began to bounce, it was several quarters, if not a couple of years, until we finally stopped hearing about how “the other shoe” was about to drop.
Another important concept that successful investors understand is the Pareto Principle, which states that, for many outcomes, 80% of results come from 20% of the inputs. For instance, it’s often observed that 80% of a company’s sales come from 20% of its salesforce and that 80% of the world’s wealth is controlled by 20% of its population. There are countless other examples, but when it comes to investing and trading, it’s important to understand and embrace the fact that roughly 80% of our results from trading will occur only 20% of the time. Traders will often find that they’re only making meaningful progress on their accounts when they’re fully in tune with the prevailing trend. They generate their biggest profits when they “have a good feel” for how the market is acting and use that to really press for gains.
It’s when the trend ends and we start to struggle with recency bias that the other 80% comes into play and we don’t make any progress for a while. We have a hard time getting back in tune with the pricing action and overcoming the bias of looking to the strategies and areas that have, up until recently, been working great. Getting in tune with the action and figuring out what’s working as condition change is a challenge, but , alas, that’s just another of the many obstacles that, once overcome, ultimately make us better traders and investors.
At the end of the day, dealing with these issues is by acknowledging them and incorporating them into our decision-making process. Is either recency bias or the Pareto Principle coloring your view of the market? Is there any evidence that what was working isn’t anymore? Are you feeling overly optimistic or pessimistic about the current action? Are you looking for evidence that challenges your current market view? Have you reminded yourself that all market cycles come to an end?
Market cycles are inevitable, necessary, and healthy. Embracing that fact is essential to market success, and appreciating the role that both recency bias and the Pareto Principle play when navigating the market will only help you further hone your craft as a trader and investor.
