Many of you know that I have written extensively on the topic of behavioral finance.
In today’s market, I am highlighting recency bias which occurs when people more prominently recall and emphasize recent observations rather than putting the current situation into historical perspective.
For example, suppose a cruise ship passenger is looking off the observation deck, and spots equal numbers of green boats and blue boats over the duration of her trip. If the green boats pass by more frequently toward the end of the cruise, while blue boats are dispersed evenly or concentrated toward the beginning, then recency bias could influence the passenger to recall that more green than blue boats sailed by. This same phenomenon frequently happens to investors.
Humans generally have short memories, but especially so when it comes to investing cycles.
During a bull market, people tend to forget about bear markets. In particular, in the last cycle growth stocks seemed like they could not go down. See the table below.
In 2020, just after the pandemic hit and the Fed increased monetary stimulus, the Nasdaq 100 exploded in value to over 35x forward earnings – well beyond 2 standard deviations more expensive than its average valuation. Many investors increased risk-taking when the index was well beyond fair value and did not think about diversification or portfolio management prudence. If one isn’t aware of it, recency bias can override our collective sense of rationality.
Last year, the Nasdaq 100 fell nearly 30%.
The index must be a bargain, right? Actually no. Even after the drawdown, the forward PE went back just to fair value with a long-term forward PE of about 21x. Then, in the first quarter of 2023, investors bid the index back up based on the idea that the Fed could cut interest rates later in the year. And with the rise of the index, some investors are jumping back into growth stocks because of recency bias and ignoring that the index is overvalued.
Our advice is to be cautious about the Nasdaq 100 and growth stocks in general right now. Exercise patience and avoid recency bias; there will likely be a better time with better prices ahead.
Source: Invesco and WSJ
