by Key Points
- Initial bad experiences can lead us to avoid taking risk even when risk-taking can provide substantial benefit.
- This is Primacy Bias at work, once again; and its impact can be significant to one’s long-term financial success.
- When making investment decisions, a great way to combat these types of behavioral distortions is to conduct a complete (beginning, middle, and end) analysis of one’s investments.
Dinner Out
Excited and optimistic you decide to try that new Italian restaurant that just opened in town. The one that’s always packed. The one that everyone cannot stop raving about. You and your guest wait on line for over an hour for a table (after a long day of work, no less), and it takes way too long for your food to arrive. To make matters worse, its raining, and your socks are soaked because you stepped in a big puddle making your way to the entrance from the overly crowded parking lot.
The antipasto, however, is decent but not spectacular. Clearly, the chefs have some kinks to work out. The main course, tender manicotti with homemade ricotta is actually good, but at this point, you’re too tired from the experience and you just want to go home. You skip dessert. On your way home, you vow to yourself to never return to the establishment.
Accordingly, whenever you hear the name of the restaurant again, your stomach tightens and you decidedly pass on any offer to eat there. In fact, you never eat there again in your ten years of living in the same city. However, over this time, that very same restaurant goes on to win stellar review after review, and acelade after acelade. But your mind is made up. You just don’t want to risk another bad experience with the place.
What’s going on here?
That’s right, it’s Primacy Bias at work. It’s quite possible you had some bad luck the first time around; nevertheless, that first impression is what you carry with you to this day.
Worst Timing Ever
Indeed, first impressions can hamper our motivation to seek risk – even when taking on risk can be greatly advantageous to one’s long-term goals. For example, let’s say you happened to make your first very large trade in the market on Friday, September 12, 2008. By this Friday in September, the S&P 500® Index has already fallen considerably from its peak in October of 2007, and the recession is nearly a year old.
The markets have experienced great turmoil, but it’s anyone’s guess as to whether the worst is over or yet to come. Given this, you decide to not let Recency Bias get the best of you so you put all these circulating market concerns behind you. Thus, you put your hard-earned capital to work on that Friday by investing in a passively managed S&P 500® Index fund.
Unfortunately, this particular Friday is significant because the following Monday Lehman Brothers went down in flames and filed for bankruptcy (read: perhaps the worst possible time to make an investment).
On Monday, September 15, 2008, “Wall Street sees worst day in 7 years, with Dow down 504 points, as financials implode,” according to CNNMoney.
Not surprising, you immediately liquidate your position the next day, having lost almost 5% in a single day, and you vow to never invest in the stock market again. At first you feel validated in your thinking because the market continues to tank for many months afterward. About six months later, by March of 2009, the S&P 500® Index continues to fall another 40% since that fateful Friday before Lehman went down. Boy do you feel vindicated (and relieved).
But something incredible would have happened to your initial investment had you just held on for long enough. In fact, the market went on to recover over the next ten years in a spectacular fashion, averaging about 11% in returns a year (including dividends). Figure 1 provides some insight of the magnitude of the initial collapse of the S&P 500® Index, which as you can see pales in comparison to the surging recovery that later followed.
However, you lost your shirt on that first trade (well not really, but it sure felt that way), so you firmly decide to sit out the rest of 2008, and still not feeling any more confident (that sting from that first trade still fresh in your mind), you decide to sit out another year. And then another. And another.
Giving in to Primacy Bias, you simply can’t get past that crushing first trade. But by this point, five years later, you may not even notice that your initial investment would have recovered and in fact grown by a healthy amount (see Table 1 below). Furthermore, after ten years, the market continues to climb. You, however have missed the boat.
Over this time, your initial impression on investing was so poor that you couldn’t bring yourself to put your hard-earned capital to work again. The opportunity cost of sitting on the sidelines this long is immense to say the least. So rather than having your money more than double over this period, it has actually lost value due to inflation by just sitting in the bank earning a modest amount in interest.
Smile
Putting this all together (Primacy Bias and Recency Bias), leads to a u-curve phenomenon sometimes described as the Serial-Position Effect, as depicted in Figure 2 below.
The notion here in Figure 2 is that when individuals are presented with a list of words in a series, they tend to recall the first and last few words the best, and the ones in the middle the worst (Coleman, Andrew (2006). Dictionary of Psychology (Second Edition). Oxford University Press. p. 688). This ties into Primacy and Recency Bias given that we tend to overweight our initial experiences and recent experiences, while underweighting the rest.
Behavioral biases can be tricky, which is why it’s important to understand them in the first place (and indeed, stay tuned for many more in this series). Accordingly, keep in mind that when it comes to investing, investors tend to focus on early wins (or losses), and recent events, but often place less emphasis on what happened in the middle.
This is particularly important when making investment decisions. For example, when we invest we’re often considering how well our strategy worked in the past; often pointing to an early win or loss (Primary Bias) or a recent win or loss (Recency Bias) in other to substantiate our next investment choice.
Given this, the best way to overcome these behavioral concerns is to actually track one’s entire performance over a lifetime of investing and compare the results with a stated benchmark. Only then can you obtain an unbiased opinion of your success and shortcomings, and therefore mitigate the influence of bias in your future investments.
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