Recency bias and managing risk
One of the greatest challenges for investors and traders is to overcome recency bias: the tendency to extrapolate current conditions into the distant future. When interest rates are low and stocks are rising in a bull market it is difficult to conceive of a time when rates will be high and growth is low. Likewise, when interest rates have been falling for decades, we expect rate cuts to continue forever.
When reality fails to meet our expectations, there is normally a painful adjustment.
Sometimes it can take years for entrenched perceptions to change. It took advisers years to realize that, under ultra-low interest rates, long-term bonds had become a speculative asset class. Counter-cyclical performance had become an illusion and many 60/40 portfolios suffered from simultaneous losses on both stocks and bonds as interest rates recovered.
It is difficult for investors to separate themselves from the herd and ask: are current conditions sustainable? When everyone is making great returns by piling into passive funds, it’s not easy to withstand following the herd. When interest rates are falling and bond investors are making large capital gains, you would be crazy to bet against them.
The prevailing wisdom is that markets are always right. I take the opposite position. I assume that markets are always wrong. ~ George Soros
But at some point in the cycle it pays to step aside and protect your capital against a sharp reversal.
Goldilocks market-timing
You don't want to be too early and forego years of profits in a bull market. You also don't want to be too late and get caught in the draw-down. Many investors are waiting for that Goldilocks moment -- neither too hot nor too cold -- to exit the market. The problem is that the right time to exit normally only becomes evident with hindsight. There is bound to be indecision from conflicting signals. By the time all signals confirm, it is normally too late.
It pays to not make dramatic shifts, from all-in to all-out. That is when investors are prone to making big mistakes. Instead it is advisable to take smaller steps, gradually increasing exposure to growth stocks as a bull market strengthens and gradually retreating as risk rises. Not a single on/off switch.
Risk Measures
Learn about the ten indicators we use to scale risk up/down.
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Author: Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.