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Recency Bias

Recency Bias and the Risk of the Recession

In 2019 investors have begun to worry about the risk of a recession in the U.S. and especially about how the investment markets might respond in a recessionary period.  The year has brought a number of reasons for concerns about recency bias and the risk of the recession.

  • The current economic expansion is now 10 years in the making
  • The yield curve, a measure of the difference between short-term bond yields and long-term bond yields has inverted
  • The trade/tariff war between the U.S. and China has escalated and may have an economic impact

Those 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.  I believe that the fear of the next recession is especially strong for investors because of a phenomenon called recency bias.

What is Recency Bias?

Investors, like all human beings, rely on a set of heuristics or rules of thumb to put things into perspective.  These heuristics help to manage all the data that comes at them in a given day by boiling things down to something more simple.  These rules of thumb, though, come with a downside because they 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 Investors

Here’s how recency bias may be affecting investors today.  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 the stock market bottomed.  The bear market prior, which began in March of 2000, shaved 49% off of stocks before the markets began their recovery.

The memory of these two bear markets is vivid in investors’ minds for two reasons.  One is that they may be the only ones they experienced as stock investors, with all the others relegated to the history books.  The other is that they were the two worst.  People remember the outliers better than the typical case.

The last two bear markets are not the norm and only one other post 1945 bear market approaches the level of losses experienced in the two most recent ones.  Generally, losses have been much more contained.  In fact, the definition of bear market, used to construct the table below, is a 20% decline in the value of stocks from peak to subsequent trough.  Expanding the definition to 19% would capture two additional data points just in the past 10 years – it would capture a 19% decline in stocks in 2011 during the Debt-Ceiling crisis and another that happened in 2018 in response to trade war worries.

Source: Bloomberg

Don’t Let Recent Outcomes Guide Fears

Investors should worry about economics and the potential for recession, but they should not let recent extreme outcomes guide their fears about the stock market.  The declines of the last two bear markets are not the norm and investors are generally subjected to less severe downturns in stock values.  There are reasons to believe that the next bear market, whenever it comes, could be one of the shallower ones.  For one, 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.  For another, global market valuations are fair in U.S. investments and downright cheap for international investments.  Lower prices relative to fundamentals may limit the downside of the next recession and bear market.

Important disclosure information

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