Behavioral Finance

What Happened to the Big Storms?

Here we are in mid-September of 2006 and not a single hurricane has made landfall in the US.

Here we are in mid-September of 2006 and not a single hurricane has made landfall in the US. Compare that to the record-setting 2005 of over 27 named storms, 14 of which made landfall. This surprised many professional weather forecasters who expected another year of near-record storms.

What does the lack of destructive weather have to do with stocks? Everything! Ok, maybe not everything. But it does underscore an important psychological principal for stock markets and forecasting: our brains tend to extrapolate the present (or the recent past) linearly into the future.

Our Stone Age brains are great at pattern recognition. The better our ancestors recognized and remembered successful ways to hunt or find water, the easier it was to survive. This archaic wiring is still in our heads. We tend to see things happening today and naturally believe they will continue in the future. Behavioral psychologists call this "Representation Bias." For instance, we've noted how optimism and sentiment indexes tend to rise after the stock market has already climbed or good GDP numbers come in. The reverse is also true. Many predicted the 3rd quarter would be a negative one for stocks because of the correction that happened in the 2nd quarter. In fact, a lot of the so-called "technical analysis" professional stock traders use is predicated on just these types of psychological mishaps.

The goal is to overcome the times where our brains try to trick us. Don't let the storm clouds in your brain rain on your investing judgment—keep your head in the sunny skies of fundamentals and logical analysis.

Source: The National Environmental Satellite, Data, and Information Service (NESDIS)

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