1 Big Mistake Beginning Investors Make
Jan 24th 2013 12:37PM
Updated Jan 24th 2013 1:10PM
Any college football fan knows that if your team is bound to lose just one game during the season, it is far better for that loss to be at the beginning of the season rather than the end. The chances of making it to a top-tier bowl game are far better if the loss is a distant memory in the minds of voters.
Indeed, a study by two professors at the College of Charleston confirmed that college football coaches tend to rank their most recent opponents -- and surprisingly, the most recent opponents of their alma mater -- far higher than other schools.
Even more telling, in presidential elections, the movement of the stock market in the two months leading up to election day has been able to predict with 90% accuracy whether the incumbent party would win or lose. And this amazingly high correlation completely ignores the movements of the market during the first 45 months of a president's tenure.
What exactly is going on here?
It's called the recency effect
College football coaches and voters alike are demonstrating a phenomenon called the recency effect. In essence, the recency effect states that when people are making decisions, they'll look to the immediate past -- rather than long-term trends -- to determine what the future holds in store.
If a college football team lost their first game but won the next 10, it's the 10 wins that coaches will remember when ranking teams. Likewise, if the market has been positive in the two months preceding an election, voters assume that trend will continue indefinitely.
Intuitively, it might make sense, but in the world of investing, being victim to the recency effect can wreak havoc on your portfolio. Recently, I've been investigating the role that certain biases play in the investing process.
Below, I'll give a real-life example of the recency effect from my own investing experience, show how to counteract the effect, and at the end, offer access to a special premium report on one stock that Fools have been following for years.
Jumping the gun
Back in the spring of 2011, my wife had just rolled over her 401(k) and was looking to invest the money. With me being a writer for the Fool, she asked me where to put it. At the time, Netflix was on a roll. We had bought a little when the stock traded for $50, but now it was hovering over $200.
Excitement over the stock, and its potential, had reached a fever pitch. I vividly remember debating with Foolish colleague Dan Radovsky about the future of the company. I was a huge bull; he pointed out many errors in my thinking -- none more so than the loss of competitive advantage because of streaming, and the costs of content acquisition.
"No way," I smugly told Dan, "this is just the beginning." And with that, I went home, and told my wife that we'd be buying Netflix.
Of course, hindsight is always 20/20, but this was a classic example of the recency effect. It would have been prudent to investigate Dan's concerns, and to evaluate -- with a cool temperament -- the stock's price relative to the company's potential.
But the overriding reason behind my decision was that Netflix was on a roll, and I didn't want to miss any of the uphill journey to come.
Some examples from today's market
If you're looking for some present-day examples of stocks that people may be buying due to the recency effect, I pointed out three of them in an article earlier this month. I noted that although Research In Motion, Best Buy, and Rite Aid had all made significant gains within the past month, I didn't think they'd be worth buying right now.
Of course, this doesn't mean that by investing in any of these companies, you're under the spell of the recency effect. You may have a well-reasoned thesis that supports your decision. The key to all of this is being able to verbalize -- or at least write down on a sheet of paper -- exactly why you are buying a stock when you are.
I have no doubt that right now, some investors -- especially beginners -- are jumping at these three stocks because of their recent performance, and not based on fundamentals.
Believe in Netflix now?
Getting back to Netflix, the company just released earnings. To get the inside scoop on the company, its earnings, and much more, check out our brand-new premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to buy or sell the stock. We're also offering a full year of updates as key news hits, so make sure to click here and claim a copy today.
The article 1 Big Mistake Beginning Investors Make originally appeared on Fool.com.Fool contributor Brian Stoffel has no position in any stocks mentioned. The Motley Fool recommends Netflix. The Motley Fool owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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