Probably Probability
By Shawn Perkins | Investing
3 minute read
If I flip a coin, what’s the probability that it’ll be heads?
50/50, right?
Let’s say that I called heads and got it right. And then I got it right on the next flip. And the next one after that. And the one after that. And after ten flips, I have called them all correctly.
After a run like that, I think anyone would be feeling pretty confident. We all know that it can’t go on forever, but it’s hard to bet against that kind of momentum.
So, what’s the probability that I’m going to call it correctly on the next flip?
Regardless of what you would interpret as favored odds, no matter what technique, education, superstition, or other power that I claim to have up my sleeve (assuming I’m not cheating), the probability of calling the next flip correctly is still 50/50. (Or is it?)
We tend to favor recent events over past events to predict the outcome of future events. This a common human behavior called recency bias. It’s the reason we think that the three-point shooter will not miss the next shot after making the last one. It’s the reason we don’t go back to certain restaurants after a bad meal.
It's the reason people invested aggressively during the dot-com bubble, or never invested again after 2008.
We have a tendency to believe that what is happening or just happened, good or bad, will continue.
It’s a flaw. It’s understandable because of your own experiences, but it’s a flaw, nonetheless.
I’m sensing that today’s market environment, similar to 2021, is suffering from recency bias.
A week ago, someone asked me what I think the market is going to do this year and I quickly said, “I don’t know.” And if you know me and my approach to investing, this should come as no surprise. But I am leaning more on the cautious side of cautiously optimistic.
When asked why, I said, “Probably probability.”
Benjamin Graham, author and mentor to Warren Buffett, famously wrote in his Intelligent Investor, “The intelligent investor realizes that stocks become more risky, not less, as their prices rise – and less risky, not more, as their prices fall.”
We are coming off back-to-back years of over 20% returns in the S&P 500. The majority of that return is concentrated in just a handful of technology stocks with momentum continuing to build. To Graham’s point, as the values of these stocks continue to increase, so does their risk.
Therefore, I believe that growth stocks, particularly those at the top of the market, are more probable to lead a decline.
I’m not saying this is the top and sell everything. And I am also not saying that you should sell all your growth stocks, either. I’m hoping that they continue.
But it is worth the consideration of reducing some of your exposure in these higher performers. You can stay invested and diversify into other areas of the market like dividend focused, small and medium cap, or international. Or just increase your safety position with a money market fund or a short-term bond fund.
I realize that this sounds like the gambler’s fallacy. Perhaps some of it is. But the beauty of investing is that you don’t have to be precisely right all of the time.
Just understand that one of the biggest risks with recency bias is that it is a short trip to reach confirmation bias, which is the acceptance of information that only confirms your point of view and turning a blind eye to the contrary.
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