SmoothSailing#25

“When is the stock market going to recover?”  “A recession is coming!  Should I sell out?”  What do we do about this big crash we’re in?” 

I get these questions all the time.  Or I’m told, “We’re down 26% this year and it’s an emergency!”

Ok, folks, relax.  Consider this.  When I hear the market is down X percent, either from friends or on the media, my first thought is, down from what?  Invariably it’s from the last high, or the highest high of all time, or the highest high of the year.  But wait a minnit!  That is a blatant case of anchoring bias, and as efficient traders, we try to learn to manage our own biases, right?  After all, what’s the difference between using the last high to measure your account or using the last low?  Nothing.  They are the same numbers in that they both represent unrealistic points in the stock market’s history.  (Using the last low would sure make people feel better.) 

Anchoring bias occurs when people rely too much on the first information they hear when making decisions. For example, if you first see a T-shirt that costs $120.00 – then see a second one that costs $100 – you’re prone to see the second shirt as cheap.  If you see it at $140, it’s now outrageously overpriced and no way you’re going to buy it.  But the reality is it may be a $20 T-shirt.  Those other prices are meaningless advertising.  The anchor – the first price that you saw – unduly influenced your opinion.  Anchoring bias is an important concept in behavioral finance.  (And shopping for T-shirts.)  And that means we should pay attention to it. 

No high has ever held, just as no low has ever held.  So why do we use those unrealistic and unsustainable markers to judge our accounts?  We pick the higher one because of anchoring bias and because it felt so good to see those big numbers in our account.  But it’s not really an accurate picture.  If you want to gauge how your account is doing, try looking at the 365 day moving average over a year.  After all, you keep your stock far longer than 365 days, correct?  A long term moving average is a more accurate picture of the stock market than picking that one day last year when markets hit a high as your reference.  We know, as rational traders, that high was an anomaly, right?  Just like the last crash or bear market or pullback, whatever you want to call it.  Neither one, the high or the low, gives an accurate picture of what’s going on.

Check out my chart.  You’ll see that IWM’s 365 day moving average has actually spent most of the year around $200.  That last spike in December 2021 was unrealistic and does not give a good picture of what the stock did over the year, any more than the drop in June does.  So why do we focus on that high?  Anchoring bias, pure and simple.  But that’s like a tourist going to Hawaii and being treated rudely by just one native.  That tourist will bad-mouth Hawaii when he gets home, even though the rest of the people there may be absolutely delightful.  We all do this to an extent, the key is to recognize when we’re doing it.

Not that I wouldn’t love to see IWM hit $240 again!