Whatever worries you about the stock market is not what a year from now you’ll wish you had worried about. It’s the unexpected that sabotages investors. Today’s concern is already factored into prices.
The occasion to mention this is the World Economic Forum in Davos, Switzerland, which occurred earlier this month. In conjunction with this year’s event, the WEF — as it does each year — compiled a report on extreme global risks, based on interviews and surveys with hundreds of thought leaders in governments, international organizations, scientific experts, the news media and more.
Almost without fail, the risks that are considered most urgent reflect what has already happened. It seems the world’s best and brightest almost always are fighting yesterday’s battles.
Take last year’s report, issued in January 2023. The No. 1 risk for impact and severity over the subsequent two-year horizon was “cost of living crisis.” It’s easy to understand why: inflation. CPI inflation in the U.S., for example, rose at an 8.0% over the 12 months leading up to that report, the highest calendar-year rate in over 40 years. This came on the heels of the immediately preceding 12-month period in which U.S. inflation rose 4.7%, itself the highest annual rate in more than three decades.
Global thought leaders suddenly realized that higher inflation wasn’t transitory and they elevated cost-of-living crisis to the top of their concerns about the future — higher even than war, starvation, political polarization or any of the myriad potential risks that could derail financial markets.
Ironically, this concern about inflation came near the point at which inflation was at its worst. It would have been far more helpful for the global thought leaders to have elevated inflation’s risk in the report from a year or two prior. But inflation didn’t even make the top 10 in the January 2022 report.
I’ve often used the occasion of these annual Davos forums to write about this “close the barn door after the horses have left” tendency. Other examples from past Davos forums include:
- In the 2021 Global Risks Report, after the Covid-19 pandemic had put the global economy into the investment equivalent of a medically-induced coma, “infectious diseases” rose to first place in a ranking of global risks. A year previously, it was in 10th place.
- In the 2009 report, “Asset Price Collapse” was the highest-ranked risk, after equity prices had already collapsed. This year, “Asset Price Collapse” doesn’t even make the top 10, even though on any objective measure the stock- and bond markets are more overvalued today than they were then.
I don’t mean to pick on the WEF, other than to point out that even the rich and famous are subject to the same behavioral tendencies as the rest of us. Psychologists refer to this universal tendency as “recency bias,” where we give more importance to the recent past than to what occurred many years ago.
Overcoming recency bias requires us to be better students of history. Your default assumption should be that something that happened a century ago is just as likely to occur again as something that happened last year. That isn’t always the case, but it is a far better assumption than believing that “this time is different” — the four most dangerous words on Wall Street.
The challenge all of us face is that the stock market’s direction over this coming year will be a function of whether things turn out better or worse than currently expected. By definition, that means we don’t know. What we do know is already incorporated into prices.
That already poses a big challenge, but there’s more: Because the markets react almost immediately when the unexpected happens, you or I will be a day late and a dollar short with our reactions. So our financial plan must be laid out in advance. If not, then we’ll constantly be in reactive mode, buying high and selling low — a surefire recipe for losing.
The late Amos Tversky, the Stanford University psychologist who helped to discover recency bias, once said: “It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on.”
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected]
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