The biggest risk in 2014 is likely to be a common one – recency bias. Otherwise known as your own brain’s tendency to focus excessively on things that have only just occurred. Of course, the markets don’t really care much for what’s just occurred. Most market participants are trying to make decisions based on what they think will occur in the future. Unfortunately, they often come to these conclusions based on extrapolating the recent past into the future. This is one of the broader causes of the herd effect and groupthink. It also contributes to market bubbles.
After a year like 2013 where many markets felt like a “can’t lose” proposition the tendency will be for many people to extrapolate the recent past into the future. They’ll deviate from their plans, reallocate a bit more aggressively or less aggressively and begin to fall in-line with the herd. But this is generally a bad idea. Letting the recent market action excessively influence your long-term plan is what I refer to as part of the multi-temporal problem in portfolio construction. And when you let your process become dictated by your emotions you generally lose control of your process and your portfolio plan begins to come unraveled.
So beware the recency bias in 2014.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.