Recency Bias And Wrong Thinking

“Invert, always invert!”

--Charlie Munger, Vice-Chairman of Berkshire Hathaway

It’s rained like crazy for months; the drought is gone for good. The economy is growing and will continue to grow, so credit and consumption expand. Housing prices are rising, they will always increase—buy a house anywhere at any price now.  The bull market’s lasted six years, it will keep on stampeding, so invest more today!

People project not only good times but also bad times into the future. The war, drought, or recession will never end. Crushed stocks will go to zero. Sell now!

This human behavioral tendency is recency bias. We think whatever is recent will continue. It can, but not indefinitely. The longer something continues, the more likely it is to change. When I was younger, the Democrats controlled both houses of Congress for what seemed like forever. Then it changed. Just as it seemed inconceivable to have a Republican House of Representatives, now it seems unimaginable to have a Democratic one.

AT&T monopolized the telephone industry. It was the only choice. AT&T owned the wires to your home and the equipment you used. Heck, the Princess phone was a revolution, let alone push button dialing! You couldn’t legally attach any equipment to your phone, not even an answering machine. Then poof! A judicial order ended the monopoly in the early 1980s and largely unleashed the telecom revolution of widespread mobile and Internet communications.

Recency bias causes poor investing decisions. The progression of stock markets is mania, panic, crash, and recovery to mania, panic and crash again. This is called a market cycle. Few pay attention long enough to see even one full market cycle. Rather, they say the current condition as all there is. This is why investors tend to buy high at times of great enthusiasm—mania—and sell out at times of fear—panic and crash. A sad flaw of dollar-cost averaging, the alleged remedy requiring investing on a regular basis, is that people tend to stop (or move to cash) in panics and resume (or move to stocks) in manias. This loses money permanently.

If we know that market cycles exist, we keep some cash on hand and wait. When euphoria reigns, we’re wary of new investments. When dejection is the rule, we put that cash to use. Don’t we want to be the people with cash when stocks go on sale, just as we choose to shop? Yes, maybe the sale will be better next month, or prices may indeed go up next month, but market cycles will always exist in a democratic capitalist system. Knowing the wheel of mania, panic and crash allows us to be close enough.  

Buffett says to be fearful when others are greedy and fearful when others are greedy. Berkshire Hathaway's Vice Chairman, Charlie Munger, further applies that principle to all sound reasoning: “Invert, always invert!" What if the opposite of what we believe is true? What if Buddhism and Streetcar Named Desire are right that everything is an illusion? How does this affect our attitude towards risk and reward?

This is how we conquer recency bias to make the most well-informed and profitable decisions we can, given an unknown future.  Invert, always invert.