The Finanacial Turmoil and Recency Effect

Since we are in the midst of a recession, and anyone denying it is really hanging on to technicalities, it’s easy to fall into the recency bias trap. The recency effect, which is a term borrowed from the psychology discipline, refers to the tendency of people to remember recent events more vividly and give them a higher consideration than historical information. Unfortunately the recency bias could result in the abandoning of logical thinking when it comes to long-term financial strategies.

Here are some examples of the recency bias when it comes to investing:

* Deciding to keep money at home( in the mattress, a safe, etc’) as opposed to depositing it in the bank and letting it earn interest.

* You decide to transfer your money into “better” investments, such as bonds and gold

* You decide to cash out of your retirement savings.

Whenever a person makes this type of decision, they are allowing recent event to directly affect their long-term planning to the point of abandoning what was once considered a sound strategy. Although, you may be right in changing your approach, this is highly unlikely.

The following are the likely results:

* Your bank doesn’t declare bankruptcy and you missed out on the interest while your money was at home.

* The stock exchange begins to recover and in the meantime bonds and gold start declining. You then move your money back into stocks which leaves you paying more in the end.

* You pay taxes and penalty fees for early withdrawal from your retirement account. Stocks recover and you are left behind on gains you could have made.

Allowing news and events to drive your strategy is never a recommended. Instead, you should come up with a strategy that will withstand both the highs and lows of the market. For example:

* Select the right asset management that is right for your time horizon and risk tolerance threshold

* Regularly contribute money to your portfolio

* Reanalyze and balance your portfolio annually

The only time to actually move out of the financial market is if your individual stocks are showing obvious signs of crashing beyond repair.

Having knee jerk reactions to financial news is not a wise decision. History, we have to remember, is a good teacher of this.

Why Many Investors Should Stay in the Market?

This post is intended for individual investors who are 10 or more years away from retirement.

With the recent downturn in the financial markets, many investors are wary of their shrinking investment accounts. As an example, retirement account have been estimated to have lost more than $2 trillion dollars during the last 15 months. Having said that, every smart investment advisor I have heard urges investors with 10+ years before their retirement not to panic and remain steadfast with their investments.

Currently, investments of the last few years have most likely lost their value, but investors who regularly contribute to their portfolio are buying in at a low point. Although the market could fall further, the ongoing investments would buy in at the lower points too. This is known as dollar cost averaging and has been shown to work even during the Great Depression. For those who believe that the stock market will recover at some point, and every expert does, then buying in at a low point is basic common sense.

Another point to make is that absolutely no person knows when the stock markets will reach a bottom and moderate recoveries do occur just as quick as a crash. Whether they will recover to their historic highs in the near future is unlikely, but further down the road they should. At any rate, holding on a disproportionate amounts of cash instead of investing it is not the wisest and profitable investment for the long term, in any economic environment.

What many investors are doing now is to cash out their stock assets due to fear of additional market drops. This is only logical if the cash is needed for an emergency purpose or if the stocks of a given company do truly show signs of being a bad investment. For long term investors, with a diversified portfolio, panic is unwarranted. What is warranted is to be educated about investing, and I am personally upset at most news anchors on TV who know very little about economics and are exuding fear and sometimes outright panic in their broadcasts.

It has been historically shown that short term investors tend to have lower returns than long term investors. This is due to such investors who sell their stocks at low points and buy later at higher points, as an emotional response. Therefore, although currently the nest egg is shrinking, history is a good teacher in showing that long term investments is the most prudent approach.

It’s also a good idea to diversify ones investments since essentially every asset class has fallen in value. Diversification into real estate, dividend paying stocks, commodoties, or bonds is advisable. The objective is to have a well balanced portfolio that the investor actually understands and to be patient until the market upheaval is over.

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