The stock market in February went up about 950 points or 3.17%. What is very interesting is that some people believed the market went down or was flat. That leads into the topic of this newsletter, which is the recency effect and the influence of that cognitive bias on our evaluation of stock market returns.
The recency effect is when people overvalue the significance of recent events, which distorts their understanding of reality. In the first 80% of February, the stock market went up a lot. In the last 20% of February, the stock market went down a lot. People often only remember what has happened recently. They remember the stock market going down a lot and assume that the month was down.
This phenomenon has a large effect on the evaluation of stock returns. A person can easily whip themselves into a hysteria by thinking their returns are significantly lower than they actually are. That can induce problematic reactions such as selling securities and withdrawing money. As we have mentioned before in these newsletters, returns have to be evaluated in a larger time scale. A few weeks is meaningless (unless you have a large expense within few weeks); you have to consider things in terms of multiple months or years.
One of the reasons that short term trading is so dangerous for the investor is that the investor is susceptible to various cognitive biases such as the recency effect. Just because a company’s stock price recently plunged, doesn’t mean that the price will continue to plunge. Between June 1, 2001 and September 1, 2001 Amazon’s stock price dropped about 58%. If you assumed the company was a failure and sold out, you would have lost out on a lot of money. 1 dollar in Amazon on June 1, 2001, would be worth 42 cents on September 1, 2001 and about 518 dollars and 8 cents on February 26, 2021.
The ultimate point of this newsletter is two-fold. First, before you make a conclusion about how some security is doing, double check the number because you might be remembering things incorrectly. Second, try not to catastrophize short term movements in the stock market. Short term movements often don’t mean anything. Evaluate how things are doing in a larger time scale.
If you have any questions about this topic or any other, please call at any time. We sincerely hope you got value from this newsletter. We appreciate your business and trust.
Daniel and Eli
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