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When it comes to investing, rely on long-term wisdom

When it comes to the market's peaks and troughs, investors often don't react as rationally as they might think. In fact, in times of extreme volatility or poor performance, emotions threaten to commandeer our common sense and warp our memory.

It's called recency bias.

A pedestrian scratching his head looks at an electronic board showing the stock market indices of various countries.
Yuya Shino | Reuters

Recency bias is basically the tendency to think that trends and patterns we observe in the recent past will continue in the future.

It causes us to unhelpfully overweight our most recent memories and experiences when making investment decisions. We expect that an event is more likely to happen next because it just occurred, or less likely to happen because it hasn't occurred for some time.

This bias can be a particular problem for investors in financial markets, where mindful forgetfulness amid an around-the-clock media machine is more important today than ever before.

Try thinking about it this way. In the high-visibility and media-saturated arena of pro sports, every gifted athlete knows that the key to success can be found in two short words: "next play."

They know the benefits of short-term memory loss cannot be understated. And from Little League baseball and Pop Warner football to the World Series and Super Bowl, coaches understand that seemingly "clutch" plays are only possible when a player's memory is a clean slate.

While sports can (and do) provide a helpful example of memory mastery, this practice is also commonly—and profitably—employed in the world of investing. Last year, for example, diversified investors were dealt a subpar hand as small company and international stock performance lagged behind their large U.S. stock counterparts.

If investors stayed disciplined, however, rebalancing their domestic winnings into their seemingly struggling foreign holdings, they'd have been pleased to see the international cohort buoying their portfolio performance in the first half of this year.

But investors have notoriously short-term memories. This creates a gain-sapping inertia that leads buyers to engage at the top and sellers to exit at the bottom.

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Recency bias is further compounded by "confirmation bias," best described as an investor's selective memory. Confirmation bias leads us to pick and choose the memories best served to fuel our established narrative.

"I'm waiting to get out of this stock until it gets back to [fill-in-the-blank]."

Really? I have some bad news. Regardless of how you remember the market, you can be sure that the market has no memory of you. The market doesn't know where you bought that stock or mutual fund or investment strategy, and it doesn't care when you'd like to sell it.

The market is going to do what it's going to do regardless of our desires.

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The best strategy going forward is simply the best strategy going forward—irrespective of what just happened and how well or poorly you performed. Whether you're the wide receiver who caught the football in the end zone or the defensive back who just got burned for a touchdown, you'll be best served to forget what just happened on the last play and make the best decision now, in the present.

But how do we know what that best decision is? We employ our long-term memory or, lacking that, someone else's.

Total amnesia is not the goal. While short-term memory can be our enemy, long-term memory, when informed by adequate education and experience, is our ally. Fortunately, in investing, we have the collective long-term memory of scores of brilliant people to draw on.

The challenge, in this information age, is to sift through heaps of articulate financial content riddled with the recency, confirmation and other biases of others in search of academically vetted, peer-reviewed and actionable content based on long-term memories.

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While it may be true that no one is entirely objective, if someone is calling for drastic or urgent action, the chances are good that their directives are highly biased. (And if a free meal is thrown in, you can be sure of it.)

Times like now, when markets are on an extended good (or bad) streak, can put our mental fortitude to the test. Headlines that reek of bias can underscore the short-term memories we're trying to forget.

Long-term wisdom can fade in its appeal as it is increasingly questioned. Rationality, discipline, balance and diversification are out. Concentration, experimentation, impatience and prognostication are in. But they don't win.

Duke's college basketball team, however, does win.

"Talent, hard work, discipline and experience are all important, but they are minimum requirements for success."

By way of disclaimer, I've never watched a college basketball game in which Duke was playing where I wasn't rooting for the opposition. It almost pains me to laud them in any context, but I just can't help it in this instance because Duke's legendary coach, Mike Krzyzewski, may be the chief proponent of a "next play" philosophy.

Regardless of the circumstances—good or bad, on or off the court—Coach K can be heard peppering those under his tutelage with the refrain, "Next play."

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He says: "You cannot do anything for the last play. Someone who is always looking in his rear-view mirror will never make the most of the current moment."

Yes, of course, talent, hard work, discipline and experience are all important, but they are minimum requirements for success. Those who excel in sports, investing and life must also have a poor short-term memory.

—By Tim Maurer, director of personal finance for Buckingham and The BAM Alliance.