What do you do, sir?

Last Updated: Mon, Dec 03, 2012 04:12 hrs

The US pollster, Nate Silver, who has now become world-famous, made his first fortune playing poker. In a recent interview he said the average poker-player lost money because he placed too much weight on recent events. When players note a pattern in recent deals, they assume this pattern will continue. Actually, cards have no “memory”, assuming fair dealing and shuffles.

“Recency” is also often to blame for mistakes in stock trading and investment. Traders place too much importance on recent price patterns, and assume those will continue. Stock prices do have memories because trading is influenced by the memories of traders. But price-patterns can change quickly when there are changes in the variables affecting businesses and markets.

Recency can lead to a reinforcement of patterns for a while. A period of trending prices, or a period of range-trading, leads to a large number of traders assuming the trend, or range-trading as it may be, will continue. Their actions then reinforce the pattern for a while. But as and when the trend does reverse or fail, they are caught on the wrong foot.

Good traders don't try to predict how long a given pattern will hold. They will take note of recent events certainly. But while they may hope that recent patterns will continue and can be exploited, they will also be prepared to change stance if there's a change in patterns.

Investors also face versions of the recency problem. Investors pay more attention to balance-sheet history than to price movements. They look at recent changes in earnings and sales growth rates and at other financial ratios. They do, however, also tend to assume that recent financial trends will perpetrate indefinitely.

This is again, not true. Balance sheet patterns change although not on a daily basis unlike prices. They change more in certain types of cyclical businesses, and they change less in non-cyclical businesses. But no business remains totally predictable. There are also base effects. A large company cannot grow as quickly in percentage terms as a small company because a big business already has high turnover and profits.

Unfortunately, investors are as often blinded by “recency” as traders. Extreme examples of the negative effects of recency can be seen in bubbles.

Take the Information Technology boom of 1999-2000, for instance. IT businesses were doubling turnover and earnings on an annual basis. Investors assumed this doubling would continue. When the growth rates dropped, many investors found themselves holding excellent IT businesses, which they had acquired only at the cost of huge capital losses.

Similar things happened in the real estate bubble of 2007. Land prices rose and newly-listed real estate developers were market favourites. Investors bought even as land prices cooled and interest rates rose, assuming the old trend would last.

Smart traders and smart investors keep a lookout for changed circumstances. There could be news that alters perception about the viability of an underlying business. There could be a favourable or unfavourable tax development, or a legal problem.

There might be an interest rate swing, or a change in some other macro-economic variable. There could be a change in management. There could also be a large change in trading volumes or price because some major player has changed attitude.

Whenever something unusual happens, it's time to review the original decision. When a trader or an investor enters a stock, he should have a clear idea of the reasons for making the entry. The expectations may differ, the underlying reasons may differ from individual to individual. But whatever these underlying reasons, the trader or investor should review regularly to check if those reasons still hold. If they change, his attitude must change.

John Maynard Keynes, who is remembered as a great economist, was also a very successful investor. He once said, “When the facts change, I change my mind. What do you do, sir?” It's a question every trader and every investor needs to ask himself on a regular basis.

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