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Use your brain, you must

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 19 December 2015.

Regular readers of this column will by now (hopefully) be aware of the many and varied behavioural biases which can turn a good investor into a bad one. These behavioural biases are where we let our emotions dictate our investment decisions, instead of being the cool, calm and rational person we all like to think we are. In our minds we’re all like Yoda from Star Wars: unflappable, wise, and all-knowing, but perhaps not green, two-foot tall and with a face like a thousand year-old prune. In reality however, we’re more like a teenager on their first date: your brain has been left behind at the Lost Property office and decisions get made in a hot and sweaty panic.

One of the most damaging biases, in terms of the potential negative effect on your investment decision-making, is recency bias. Recency bias is where we place too much importance on recent events, for the sole reason that whatever happened, happened recently, rather than in the distant past. This makes us believe that whatever is happening now is likely to persist well into the future. For example, in the United States there is a high level of correlation between the price of petrol (or gas as it’s called in the US) and sales of gas-guzzling SUVs. As the petrol price falls, sales of thirsty SUVs rise in almost perfect unison. It’s not hard to see the irrationality in this – because the price of petrol has fallen over the past six months (for example), you rush out and spend $40,000 on a car which you might own for the next five, ten or fifteen years. Is it likely that the oil price, and thus the petrol price, is going to be the same in five, ten or fifteen years, as it is now? Of course not. But everyone who buys an SUV based on falling petrol prices has just made a ten or fifteen year investment based on what has happened in the past few months. A perfect example of letting recent events dictate our decision-making, rather than taking a more long-term view.

Reactions to the volatility in financial markets over the past year are also examples of recency bias. When the oil price reached over $100 in March 2008, investment bank Goldman Sachs confidently predicted it would soon reach $200. It didn’t, peaking at $147 per barrel three months later. In September this year, after the oil price fell from $145 to just $45, Goldman Sachs confidently predicted it would fall to just $20 per barrel. Both of these predictions look like recency bias in action. My advice to Goldman Sachs: sack some of those teenagers you employ, and hire more Yodas.