Investment Lessons From Your Thanksgiving Turkey

Thanksgiving seems an appropriate time to consider the “Turkey problem” as it relates to risk management. Nassim Taleb introduced the world to the “Black Swan” concept and used this example to illustrate the issue. Imagine the life of a turkey where a kind farmer feeds and tends to it every day until suddenly, on the Wednesday before Thanksgiving, the situation takes an irrevocable turn for the worse. The turkey has only observed a positive trend during its lifetime up until that fateful Wednesday and is the fattest and happiest at a point that turns out to be the time of maximum risk. It recalls another favorite quote attributed to Mark Twain: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

Interestingly, expecting trends to continue is an automatic human response to our built-in tendency for our brains to see patterns even when they do not exist. According to Jason Zweig in Your Money & Your Brain, this propensity to look for patterns makes sense since our primitive brains were tuned to the immutable physical laws of nature, like when lightning strikes, thunder follows. Stocks and the financial markets do not follow the rules of nature, so our trend-seeking behavior can often lead us astray. In addition, humans also suffer from “recency bias.” In other words, we weigh the more recent experiences more heavily when predicting future outcomes. This bias is why people expect stocks to continue to rise if they have increased recently. To be fair, there is evidence of autocorrelation and momentum in stock returns, but this is not an unfailing natural law. Instead, this tendency for stocks performing well to continue to perform well does not work all the time, and the signal tends to reverse eventually. Investors using momentum need to have a disciplined…

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