Recency bias can be a big reason that investors tend buy at highs, and sell at lows. It blinds investors to the fact that companies’ margins and market multiples tend to revert back towards long-term averages over time.
The Power of Statistics and Rule-Based Approaches
People’s tendencies to make decisions based on the examples that most easily come to mind, and particularly those examples that confirm what they already believe or resemble what they have recently seen, are just a sampling of the various mental glitches that can lead to bad decisions.
This is why, in many fields characterized by high degrees of uncertainty, statistical formulas have been shown to provide better predictions than not only people in general, but also better than collections of experts. Daniel Kahnemans’ book Thinking Fast and Slow explains how this has been true in a wide range of fields, from estimating the likelihood that a convict will violate parole all the way to whether a candidate will have success in pilot training.
A favorite example, cited in his book, involved predicting the quality of top Bordeaux wines. These wines, meant for aging, do not develop their taste until years after they have been bottled and this makes them difficult to assess upon initial release. Wine collectors have traditionally turned to experts who, after tasting from the barrel and reviewing the vintage’s growing conditions, opine on whether a new wine looks likely to be extraordinary or something less so.
“But, then, in the Eighties, an economist and wine enthusiast named Orley Ashenfelter thought he could do better, with an algorithm. If you’re interested, the algorithm was: ? price = -12.15 + (?1 * Winter rainfall) + (?2 * Average summer temperature) + (?3 * Harvest rainfall) + (?4 * Age of Vintage). Pundits were furious and appalled: Robert M Parker, America’s best-known wine expert, called it “ludicrous and absurd.” But it wildly outperformed even the best expert predictions.” 
You can observe the same power of simple formulas in the world of equity investing. For example, there is extensive evidence that selecting portfolios of companies that that are inexpensive in relation to their fundamentals (earnings, sales, book values, etc.) would have yielded better long-term results than owning the market as a whole. Why might this be?
Well, the same human biases discussed in this letter (and many more) can create illogical market prices. To get excited by recent gains or depressed by recent losses is a natural human tendency. To extrapolate recent events into the future and to seek comfort through ‘expert’ opinions and the herd are also very natural human tendencies. These tendencies, however, are not aligned with the sound principles of buying low and selling high.
A formula for buying inexpensive companies is simply a means to benefit when other investors’ behavioral biases periodically allow a good company to be offered for too low a price.
How Is This Relevant Today?
Two stories that equity investors currently embrace are reflected in these facts:
- Americans’ expectations that stocks will keep rising are at a 17-year high. They haven’t been this bullish since January 2000. 
- Investors favored passive over active strategies by a record margin in 2016. 
The stories might be summarized as stocks are going up and passive investing is the way to go. In what ways might these stories be driven by behavioral biases and be missing some important statistical context about the state of the market?
One observation is this bullishness and the growing consensus around the merits of passive investing come after 7 years of mostly straight up markets. Despite the markets having become very expensive in relation to corporate earnings, investors apparently feel comfortable extrapolating what has recently occurred into the future.
But, the patterns of history suggest this comfort will not be long-lived. Previous market cycles show that the time to be bullish is after a market, sector or a stock has made a big decline, not a long advance. Remember January 2000 when investors were very bullish and March 2009 when investors were collectively terrified? The human mind apparently has some quirky wiring that, in environments characterized by reversion to the mean, often points in the wrong direction.
A similar blindness may be reflected in the current consensus around the merits of passive investing. True, active managers as a whole will underperform the average market return by the amount of their fees. But, the relative success of passive vs. active investing has been cyclical (take a look at this chart). During times such as now and the late 1990s, when markets steadily increased and many companies became very expensive, active managers have looked really bad. Perhaps it is because many active managers, being sensitive to companies’ intrinsic values, are unwilling to hold companies that are very expensive in relation to fundamentals or, as is the case with market-cap weighted indexes, to blindly overweight them.
We anticipate that, during the years ahead, it won’t prove smart to be highly allocated to the most expensive companies and under allocated to companies that are less expensive in relation to fundamentals. If this occurs, active managers who remain disciplined in their value-orientation may begin to look at lot smarter, at least in relation to the passive strategies currently in vogue.
Back to Euclidean
We formed Euclidean because we believe a systematic approach reduces the risk of counterproductive emotions and biases influencing how we allocate capital. We also believe that it provides an opportunity to profit from a cause-effect relationship that persists across investing history. Namely, the cause being investors’ mistakes created by humans being human and the effect being that good companies are periodically offered at low prices.
We believe that this particular cause-and-effect relationship is a timeless one. Human nature is a powerful force. The effects of human emotion and cognitive biases have been apparent through centuries of financial history, and they can be seen today with domestic valuation spreads as wide as anytime during the past 50 years, other than an extreme peak during the Internet bubble.  This spread has widened as growth stocks have steadily advanced while companies that are inexpensive in relation to fundamentals have had muted returns. In the past, these types of environments have consistently ended with big rewards for value-oriented investors who maintained their discipline through the cycle. 
Opportunities like this exist because very few investors seem interested or able to maintain the long-term focus and discipline required of value strategies. Therefore, we like Euclidean’s chances. Technology innovation will surprise us, industry structures will change, and regulations will evolve, but the underlying causes we rely on – human biases, loss aversion, recency bias, desire for the comfort of the herd, etc. – are as robust today as they ever were.
The opinions expressed herein are those of Euclidean Technologies Management, LLC (“Euclidean”) and are subject to change without notice. The information provided in this report should not be considered financial advice or a recommendation to purchase or sell any particular security. Euclidean Technologies Management, LLC is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Euclidean including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request.