Bull Market and Bad Habit of Being Right

Picture this: It is 2019, and you are watching the cricket World Cup finals. India is playing Pakistan. It’s the start of the 42nd over of India’s run chase. Yuvraj Singh has just hit Pakistan’s lead spinner for five sixes in the first five balls of the over.

Yuvraj is on a hot streak. He had hit the same spinner for six sixes in a row in a match on the same ground last year. So, he is going to hit the next one out of the park as well, right?

Keeping aside the patriotism that is much seen in an India-Pakistan match, you, like most Indian cricket fans would unhesitatingly reply, “Yes!”

Well, that assumption doesn’t say as much about Yuvraj’s skills as it does about how our brains work. In fact, it tells a lot about how we humans have evolved.

Anyways, coming back to your assumption (conclusion) that Yuvraj will deliver even the last ball for a six is, well, way off the mark. Statistically, Yuvraj isn’t significantly more likely to hit a six on this last ball than he is to get caught at the boundary, whatever hot streak he may be going through.

This ‘jumping to conclusion’ tendency is called Recency Bias. Like most other cognitive biases, this is also etched deep in our mental wiring. Dan Ariely, a professor of behavioral economics at Duke University and the author of books including Predictably Irrational writes on Recency Bias –

We look at the most recent evidence, take it too seriously, and expect that things will continue in that way.

Recency makes it very difficult for us to appropriately understand and navigate the perpetual, but irregular, cycles that markets, economies, and companies go through. Ray Dalio, the founder of hedge fund Bridgewater Associates, captured this fact well in his video How the Economic Machine Works –

Now, Recency Bias worked excellently well when our ancestors were roaming the African jungles. If wild beasts had shown up at the same watering hole a few days in a row, it paid for our ancestors to hunt at that same spot the next day. However, carrying through the same tendency to a hunting game that has shifted to the economic and stock market jungle is often dangerous.

Especially when you are an investor who has had a successful run in recent times, falling for Recency Bias especially after being on a hot/winning streak is one of the most dangerous things that can happen to you.

Consider what has happened in the stock market and with investors around you ever since the start of this year. Stocks, especially small and mid-caps, have risen sharply. In fact, stocks that are up ‘only’ 20-30% during this period are being seen as weak performers. The count of experts appearing on television recommending new multi-baggers has also risen sharply. And not just television, I can sense a gradual increase in the number of stock market experts even among those who have nothing to do with the stock market. Look at Twitter feeds, and you would often find people boasting about their stock picks made just three months back. Look at your portfolio, and most likely you would be smiling looking at the way your stocks have done in the last three months.

Of course, we are not yet at the peak of the bubble because one can still hear voices concerned about the market’s rise. But it’s again that time when you must be extremely cautious, especially if you have been proved right in recent times.

Before the Music Stops
Before moving forward, let me take you back to a time during late 1999 through early 2000, near the peak of the dot-com bubble, when the legendary George Soros and his hedge-fund team was working on how to prepare for the inevitable sell-off in technology stocks.

The man in charge of Soros’ high profile technology funds was Stanley Druckenmiller – one of the best-performing hedge fund managers of all time, till date – and he was busy warning his team that the sell-off could be near and could be brutal.

As the markets soared further in March 2000, Druckenmiller was quoted as saying, “I don’t like this market. I think we should probably lighten up.” Soros himself would regularly warn his team that tech stocks were a bubble set to burst.

Despite this, when the sell-off finally did begin in mid-March 2000, Soros Fund Management wasn’t ready for it. His funds were still loaded with high-tech and biotech stocks. Just in five days, starting 15th March, Soros’s flagship Quantum Fund saw what had been a 2% year-to-date gain turn into an 11% loss. By the end of April, the Quantum Fund was down 22% since the start of the year, and the smaller Quota Fund was down 32%.

Post that, in April 2000, Soros said at a conference, “Maybe I don’t understand the market. Maybe the music has stopped, but people are still dancing.”

The same month, at another conference, Druckenmiller confessed, “It would have been nice to go out on top, like Michael Jordan. But I overplayed my hand.”

Here is how Druckenmiller summarized his experience of 2000 in an interview late last year (Nov. 2013) –

I bought the top of the tech market in March of 2000 [after quickly making money in the same space in mid-late 1999] in an emotional fit I had because I couldn’t stand the fact that it was going up so much and it violated every rule I learned in 25 years.

I bought the tech market very well in mid-1999 and sold everything out in January and was sitting pretty; and I had two internal managers who were making about 5% a day and I just couldn’t stand it. And I put billions of dollars in within hours of the top. And, boy, did I get killed the next couple months.

Remember “Risk”
Howard Marks of Oaktree Capital, wrote this in his seminal book The Most Important Thing –

In bull markets – usually when things have been going well for a while – people tend to say ‘Risk is my friend. The more risk I take, the greater my return will be. I’d like more risk, please.’

The truth is, risk tolerance is antithetical to successful investing. When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so… and risk compensation will disappear. But only when investors are sufficiently risk-averse will markets offer adequate risk premiums. When worry is in short supply, risky borrowers and questionable schemes will have easy access to capital, and the financial system will become precarious. Too much money will chase the risky and the new, driving up asset prices and driving down prospective returns and safety.

Risk, which Marks and Warren Buffett have often defined as losing significant amounts of money and permanently, often moves in the same direction as valuations.

In other words, risk increases/decreases as valuations rise/fall. At the same time, high valuations imply weak prospective returns, while depressed valuations imply strong prospective returns. Consequently, both Marks and Buffett suggest that risk is lowest precisely when prospective returns are the highest, and risk is highest precisely when prospective returns are the lowest.

Economist and investment strategist Peter Bernstein said –

The riskiest moment is when you are right.

In one of his posts from 2015, Jason Zweig wrote this –

In much of life, doing things right over and over again is a sign of skill; expert musicians, for instance, rarely hit a wrong note. And the skill of one professional musician doesn’t make it harder for the others to be equally expert. But in the financial markets, where so many investors are highly skilled, their actions cancel each other out as they quickly bid up the prices of any bargains—paradoxically making luck the main factor that distinguishes one investor from another.

And a streak of being right can make anyone forget how important luck is in determining the outcome.

Watch out for that streak of being right, dear investor!