I imagine many of you have heard the story of the Blind Men and The Elephant. I believe it may have been the sixth grade or so when I was first introduced to it. This story originated in the Indian subcontinent but gained worldwide popularity after John Godfrey Saxe, an American poet, created his own version.
“Once, 6 blind men were asked to describe an elephant. The first one touched its side and described the elephant like a wall. The second one touched its tusk and said it was a spear. The third one touched its trunk and described it a snake. The forth one touched its knee and called it a tree. The fifth one touched its ear and said it was a fan. Finally the last one touched its tail and described the elephant as a rope.“
Notice that none called the elephant an elephant. Why is that? They were actually all correct from their own perspective, but each perspective led to an incomplete understanding. They all described the elephant differently. Their descriptions were simply based on the part of the elephant they touched.
Let’s consider the stock market as the elephant and investors or participants in the market as the blind men.
Often investors view their stock market portfolio performance from a current or recent results perspective. This can lead to an incomplete understanding and this phenomenon actually has a name. This phenomenon is termed “Recency Bias” or “The Party Effect.”
Consider a simple but extreme example of two clients that work with the same investment adviser. The first client joins the adviser in June of 2007 and bought into the adviser’s recommended portfolio, which happened to resemble the S&P 500 index. The S&P index in June of 2007 was approximately 1531. The second client joined the adviser in November of 2008 and invested in the same portfolio. The S&P index was approximately 969 at that time.
The two clients attended a 4th of July party in 2009 together and were talking with several mutual friends about what they thought of the stock market and their adviser. I’m sure you can see where this is leading.
Client 1 thought the market was way too dangerous and that the adviser is not worth the money paid him. This adviser had managed to lose him almost 17% of his original investment as the S&P index was currently hovering around 1276. Client two, on the other hand, thought the adviser was the smartest market guy he had ever met and loved the stock market because his portfolio was up 32% from his original investment.
From this example, can you see where the Party Effect and the Recency Bias got their names? Just like the blind men and the elephant, the clients at the party had different perspectives since they experienced limited and different aspects of the stock market. Their descriptions were correct, but didn’t incorporate a full understanding. And note the Recency Bias. Both clients had strong options of the adviser and the market based on their recent experiences, and these recent experiences will no doubt influence their thinking for a while to come.
When you are driving along and you see a speed trap – you slow down. However after you’ve passed through it, you tend to continue to drive more slowly because you imagine that there is another right around the corner. Similarly, people tend to panic when their portfolio goes down with the market and they think there is more to come. On the flip side, investors tend to feel excited when their portfolio goes up and they tend to think it will continue to go up. But needless to say, these behaviors may prove to be damaging to the ultimate value of the portfolio.
What we need to remember is to focus on the long term goal. Markets go up and down every day! The current performance of the market does not alter one’s goal to retire comfortably. And if one has prepared for the market volatility and can generate the income needed, regardless of which way the market is moving, then that comfortable retirement is just around the corner.