I believe that the fear of the next recession is especially strong for investors because of a phenomenon called recency bias, which may encourage investors to make rash decisions that are not in the best interest of their long-term goals.
In 2019, investors have begun to worry about the risk of a recession in the U.S. They may be especially concerned about how the investment markets might respond in an economic downturn. Memories of recent downturns put them at risk of letting recency bias negatively affect investment strategies.
Analysts have reason to be concerned. Several recession indicators point to the possibility of a downturn, including:
- The fact that the current economic expansion is more than a decade old and the longest in history
- The yield curve—the difference between short-term bond yields and long-term bond yields—has inverted, so short-term bonds are returning at higher rates
- The trade/tariff war between the U.S. and China has escalated and may have an economic impact
Those are all present real, vivid risks and they raise the chances that in 2020 and beyond we will see the first recession in America in over 10 years. Recessions are worrying for investors because they can be associated with bear markets in stocks and other risky investments. Bear markets are defined as a 20 percent decline in the value of stocks from peak to subsequent trough.
What is Recency Bias?
Investors, like all human beings, rely on a set of heuristics, or “rules of thumb,” to help them put matters around them into perspective. These heuristics help to manage all the data they process in a given time, boiling down the information into simpler concepts. These rules of thumb, though, come with a downside because they may lead to biased decision-making. The heuristic investors face today is recency bias–relying only on the most recent history to make predictions about the future.
How Recency Bias Affects Business Owners
How might recency bias affect business owners preparing for recession? They may be so fearful of another Great Recession that they are tempted to take extreme actions that could undermine their investment efforts and not position them well for the eventual recovery. Consider that the last two bear markets, both of which occurred around the time of a U.S. recession, were the two deepest bear markets U.S. investors have faced since 1945. The bear market that began in October of 2007 erased 57% of the stock market’s value when it bottomed. The bear market prior, which began in March 2000, shaved 49% off of stocks before the markets began their recovery.
If we expand the bear market definition to include times when the markets experienced a 19% decline, two more periods of decline have happened within the past decade: a 19% decline in stocks during the Debt-Ceiling crisis in 2011, and another sparked by trade war worries in 2018.
The memory of the last two bear markets is vivid in investors’ minds for two reasons. One is that these may be the only bear markets they experienced as stock investors, with all the others happening before they began investing. The other is that these bear markets were two of the worst in history. People remember the outliers better than the typical case. However, typically losses have been more contained. In fact, there was only one other post-1945 bear market that approached the level of losses experienced in the two most recent bear markets.
While it’s impossible to predict the severity of a bear market accurately, there are reasons to believe the next one will not be as acute as those in recent memory. Unlike the housing price bubble in the prior recession or the dot.com bubble in 2000, the economy has not built up excesses in asset prices. In addition, global market valuations are fair in U.S. investments and present attractive opportunities for international investments. Lower prices relative to fundamentals may limit the downside of the next recession and bear market.
Don’t Let Recent Outcomes Fuel Fear
Even though the downturn may not be as extreme, business owners should still act to recession-proof their businesses, working in tandem with their wealth managers and financial advisors. However, they should not let recent extreme outcomes lead them to extreme decisions. Abandoning your carefully crafted investment plan without consulting your expert team of advisors can be a recipe for disaster.
When you created your investment plan with your wealth management advisor, you likely took into consideration possible downturns. This type of market fluctuation happens as part of the economic business cycle. If you are concerned about your portfolio and the effects of recession, contact your wealth management advisor to create a plan to help mitigate risk.
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