Alpha Power Investing Newsletter

February 12, 2010

Psychological Risk

Investors today have a lot to worry about - unemployment, government spending, the national debt, the housing crisis, global recession, coming inflation, etc.

Practically every day I talk to investors who are sitting on piles of low-returning cash because of their apprehensions about the economy and their fear of the future.

When I ask them what would change their minds and begin investing again, the answers are vague but clearly they believe that some condition in the future would make them feel comfortable with risk - they just can't specify what it would be.

I think it's appropriate to divide investment risk into two categories: first, there's the actual risk of the market, it's out there; second, there's the risk posed by our own psychology, it's in here.

As human beings, we all have a desire to see into the future and remove as much uncertainty as possible. To do this, we construct "stories" and theories that make sense out of the myriad and often conflicting elements in the equation of life. Unfortunately, our demand for certainty often outstrips our rationality and we fall prey to something psychologists call "recency bias".

Recency bias is the tendency to explain (or predict) the future in terms of recent events. In hindsight, we can see the causes of events or conditions, and we use this as a model for projecting the future course of events.

The problem is …it doesn't work.

This is clearly demonstrated by research into the behavior of mutual fund investors.

Each year about 70% of new money going into funds is directed into a small number of funds which have had the best recent performance. Poor recent performance causes investors to exit funds for better performing funds. As a result, mutual fund investors, in the aggregate, underperform the market and the funds themselves. Some studies have shown that the average mutual fund investor only captures 50% of the long-term return of the funds he or she invests in.

The reason for this is pretty simple. The recent performance of a fund is almost always the result of a temporary condition favoring the fund's special style or niche. These forces change. Thus investors are attracted to these funds near a temporary high and then exit as they revert to the mean. As a result, they are penalized for buying high and selling low.

This behavior has been documented again and again for both professional and non-professional investors. It is the effect of recency bias and it will never change.

Successful investors have learned how to break out of this psychological trap.

One way out of this dilemma is to view the market as subject to recurring cyclical forces. There are certain time periods when investors' expectations tend to rise, no matter how bleak the larger economic background conditions appear to be. I call these time periods "Power Zones" and they come around with predictable regularity.

There is an annual "Power Zone" from November to June. Stock market returns are skewed into this period over time. Mid-Cap stocks (which I examined in the last newsletter) are especially favored by this annual cycle. Investors who accept market risk during this period have, over time, enjoyed superior returns with 40% less risk than buy and hold.

To see the effects of this annual "skewing", which is caused by the forecasting industry worldwide, see the Power Indexing section of my website ( This type of "behavioral" investment strategy short-circuits the influence of "recency bias" by ignoring complicated and dimly understood economic factors which are constantly changing. These factors offer no consistent principles for rational decision making and, more often than not, cause investors to project the conditions of the recent past into the indefinite future. This is the ultimate cause of investment bubbles and panics.

Jerry Minton, Ph.D.

© 2009 Alpha Investment Research Inc.
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