It wasn't too long ago that we were worried about what to do when the Dow fell to the unthinkable level of 7,500. And recently, the Dow seemed to be making a beeline for 6,500 or lower. Everyone was, to put it mildly, freaking out.
But that's OK. That's what everyone was doing on the way up, too. And today, many are doing it again, thinking the last two months have signaled the end of the bear market.
Consider: During the last two bubbles, we had companies with no earnings and negative cash flow valued as if they were big blue chips ... commodity prices climbing and climbing ... risk diluted away to nothing ... and stock and housing prices seeming to go in only one direction: up.
With just a little bit of thought, you'd recognize that all those things were crazy.
During this bear market, we've had people willing to pay the U.S. government to hold their money ... credit card companies paying customers to close accounts ... Warren Buffett's Berkshire Hathaway losing its AAA credit rating ... and stock and housing prices only seeming to go in one direction: down.
With just a little bit of thought, you'll hopefully recognize that all these things are crazy, too.
Investors -- heck, humans in general! -- suffer from something called recency bias. That is, we tend to give more weight than we should to stuff that's happened in the recent past. When stock prices go up, we think they'll always go up – and vice versa. Really, both should seem absurd, because we know things change all the time. But we still think this way.
So what can you do?
It’s impossible not to be human, of course, but human emotions are sometimes the biggest barrier between you and multibagger returns. To fight recency bias in your own investing, try these three strategies -- all centered on keeping a long-term, forward-looking focus.
First, invest in companies with a sustainable competitive advantage, such as Procter & Gamble (NYSE: PG ) or Johnson & Johnson (NYSE: JNJ ) . These companies sell stuff people use every day, generating intense brand loyalty. (My wife and I have used P&G's Tide for 20 years.) With loyalty like that, these companies should be around a long time, growing earnings. As earnings grow, so does the stock price. Sustainable competitive advantages can give you some peace of mind during rocky times.
Second, avoid trading in and out of stocks during this volatile period. Frictional costs -- taxes and commissions -- will kill you. It's like being nibbled to death by ducks -- each little bite may not seem like much, but add them all up and you get clobbered. A study a few years ago by Barber and Odean of UC Davis found that investors "pay a tremendous performance penalty for active trading."
There's something else to consider if you're prone to pressing the "sell" button when things get scary. Nearly every great performer has dropped at least 25% somewhere in its multibagger run. Selling a great business when times get tough is a good way to miss out on some fantastic returns when things turn around. I could give any number of examples, including Arcelor Mittal's (NYSE: MT ) 50-bagger run beginning in late 2002 or Apple's (Nasdaq: AAPL ) 30-bagger climb starting in the spring of 2003. Investors who sold out after the first (or second, or third) 25% drop missed out on some epic gains.
Third, remember what Peter Lynch pointed out in his books: The market doesn't care what you own. You are not a genius for investing in a stock that goes up in the short term, nor are you a failure when your stock drops. A lot of short-term stock movement is just random noise. Your true abilities are measured over the long term.
Speaking of failures ...
Warren Buffett certainly follows the above advice. Over the past year, he's invested in companies -- US Bancorp (NYSE: USB ) , for instance -- and gotten clobbered as their share prices dropped. But just this past weekend at the Berkshire annual meeting, he once again reminded the world that he's not looking at today; he's looking out several years. He believes that these companies -- along with long-term successes such as Coca-Cola (NYSE: KO ) , up 600% from his cost basis -- have a clear competitive advantage and will reward him handsomely over time.
Was Buffett wrong for having invested in US Bancorp? Only time will tell. But he doesn't suffer from recency bias, as he showed in his last letter to shareholders:
Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21-1⁄2% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges. Without fail, however, we’ve overcome them.
Now, I'm not saying that times are no longer tough. They still are. But pulling your hair out because you think things will never improve won't help anything, least of all your portfolio (or your head).
Instead, take a deep breath and get back to the basics. Think about the three points above. If you need help, Tom and David Gardner follow these principles every month when recommending companies in our Motley Fool Stock Advisor service. Multibagger winners like Marvel Entertainment (NYSE: MVL ) -- up 850% since its original recommendation -- have helped the brothers beat the S&P 500 by 41 percentage points in the service's seven-year history.
For a free look inside and to find out which two companies they've recently chosen, using these lessons to avoid recency bias, click here.
Jim Mueller owns shares of Berkshire Hathaway, J&J, Coke, Marvel Entertainment, and Apple, but no other company mentioned. Apple and Marvel are Stock Advisor recommendations, J&J is highlighted by Income Investor, Coke is a choice of Inside Value, and the Fool owns shares of Procter & Gamble. Our disclosure policy is like a cat, ignoring everything recent.