First a quick review: Much of financial theory and how to invest is based upon what the “rational person” would do. Unfortunately, as much as we would like to think so, no one is completely rational. Behavioral finance is the study of irrational situations that people fail to guard against in financial situations.
Another behavioral bias to learn is “recency” bias. The best way to describe this bias is that we all have a tendency to project the most recent history into the future.
For example, if the stock market is down, many will believe the market will continue a downward trend since it has been going down lately. On the flip side, if the stock market is up, many will project a continuing rising trend.
This bias causes a lot of investors to buy high and sell low. The result is a vastly diminished portfolio over the years.
Often times using a statistical regression line re-enforces this bias. A statistical regression line does not estimate inflections (changes in direction) very well. It simply uses the past relationships to project into the future. The result is a mathematical model that continues the trend forward.
Because of the mathematical construction of a regression model, any regression model should not be taken as the “holy grail” and should be supplemented with other analyses. Unfortunately, because regression is a mathematical model, there is a tendency to give its results a certain “seal of approval”. Be careful!
Always recheck your own thinking and the basis of that thought for biases. I often use a mental checklist of the many biases when I am thinking about a situation. This is not the place to “let your gut make your decision”. If you do, you could be very unhappy with the outcome!
