The surest path to investing failure is to strategize for the future by looking at your most recent wins.
They call this recency bias in the field of behavioural economics. In trying to make sense of what’s to come, you put more weight on recent events than historical ones. Now is a good time to stop doing that.
The pandemic and Russia’s invasion of Ukraine have added massive amounts of uncertainty to the global financial system, which has so far held up brilliantly well. Looking ahead, the ideal outcome would be that the pandemic eases and negotiations end the Russia-Ukraine war. The global economy could then serenely transition to a new period of consistent growth that helps both government and individuals improve their financial situation.
This may happen. It seems like the stock market is betting on it, given its moderation of the past week. But we should also consider the possibility of disappointments ahead for two of the biggest indicators of financial success in modern life – the price of stocks and the price of houses.
Taking on risk was a rational, effective thing to do in the past two years. Stocks, houses and cryptocurrencies have delivered the kind of gains we may not see again for decades, if ever. But there is always a turning point for financial assets that soar in value.
Before continuing, we have to distinguish between short-term risk takers and people who plan to hold onto their stocks and houses for the long term, say five to 10 years or more. The effects of pandemics, wars and other calamities are distressing and awful, but if you invest for the long term they are not an immediate threat to your financial well-being.
If you’re a risk-taker who lives in the moment, then you need to be watchful for changing financial conditions. War in Europe could turn out to be one of those moments. The conflict itself has so far been too contained to shake the global financial system. But it’s causing disturbances in a global economy that was already struggling to deal with the pandemic.
Inflation is the best example. Pandemic-driven forces pushed up Canada’s year-over-year inflation rate in January to a 30-year high of 5.1 per cent. We now have oil and natural gas prices rising as a result of the invasion of Ukraine, and grain prices have jumped as well. The global supply chains that were already disrupted by the pandemic are experiencing fresh adversity.
Growing inflationary pressures on the economy coupled with high oil prices is a nasty combination. Higher inflation argues for higher interest rates to cool economic activity, while high oil prices are on their own a big weight on economic growth.
The Bank of Canada will almost certainly start a cycle of interest-rate increases on Wednesday. Should the bank be aggressive to squash inflation, or go easy so as not to do anything that might derail the postpandemic recovery and steer us toward recession? A wrong call could affect the economy for years to come.
Through good times and bad, your biggest challenge as an investor isn’t making money. It’s keeping it when the financial world decides that risky behaviour will be punished, not rewarded. That’s why it’s so important to recognize recency bias in your financial planning.
Five financial moves to re-evaluate now:
- Bidding to buy a house at the full limit of your affordability as defined not just by your mortgage, but also living costs such as daycare, car payments and saving.
- Buying investment properties to flip in the near term.
- Dropping a bundle on a premium vehicle with a thirst for gasoline.
- Making aggressive bets on stocks without a long-term time horizon.
- Making aggressive bets on newer types of financial assets such as crypto or non-fungible tokens (NFTs).
The question you have to ask yourself when thinking about financial risk is what would cause you more regret – getting out too early, or waiting too long. House prices could keep rising, which means that highly leveraged property you buy tomorrow could pay off if you can flip it quickly or find a renter to carry it for you. Stocks could end up having a strong year.
But from where we are today, it sure looks like the downside for risky assets is bigger than any potential remaining upside. War in Europe is just a reminder of this.
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