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By Christine Benz | 06-14-2013 01:00 PM

Behavioral Traps in a Strong Market

Author Carl Richards urges caution of the many biases that can creep into investors' mind-sets and how they might be playing out today.

Note: This video was originally posted in June 2013; we're re-featuring it as part of Morningstar.com's July 2013 special report: Inside the Investor's Mind.

Christine Benz: I'm Christine Benz for Morningstar.com. Very strong market environments can lead to all sorts of behavioral mistakes. Joining me to discuss that topic is Carl Richards. He is director of investor education at the BAM Alliance.

Carl, thank you so much for being here.

Carl Richards: Thanks for having me.

Benz: So, Carl, the market has been really quite good. Investors have begun gravitating toward stocks. But let's talk about some of the behavioral pitfalls that they might fall prey to at times like these. One is what behavioral economists called recency bias. Let's talk about what that is and what sorts of behavioral mistakes investors can make?

Richards: Yeah, yeah. That is so fascinating because what's interesting about all of these mistakes that we make, these biases that we fall prey to is knowing the name of them. It helps a little, but we can know exactly what bias we have a tendency to fall for, we can know what it's called, and then we still do it. So, hopefully, at least knowing the name we'll at least be able to know what it's called before we do something dumb.

So, this recency effect is just this idea of, as humans we tend to take the recent past and project it indefinitely into the future. And normally it used to feel like the recent past was three years. The recent past now seems to be like three days. It's what leads us to say things like, "Oh, you know what I'm comfortable, the market's going up. This is great. I'll put in based on the past." It also leads us to say things like, "I'm getting out of this market. I have to get out. I will never invest again. Things will never get better when things are bad."

It also leads us--and this is really important--to forget what risk is after we've had three relatively calm years where the market's operating like back in 2002, '03, '04, and '05, where the market--really in '03, '04, '05 and '06--the market was like a 12% certificate of deposit, if you remember. There was almost no volatility. At that point risk could become an arbitrary concept. We couldn’t even remember it because of [the high returns in] the recent past; super tricky. So, to me the answer is to lengthen your definition of "past" and remember what you felt like last time the market was like this, just remember as you make your decisions that things change.

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