Normalcy Bias

Normalcy bias is a personality trait that causes people to underestimate the possibility and magnitude of extreme events.  When presented with evidence of impending tragedy, normalcy bias leads people to see the warnings through only the most optimistic lens.  At its extreme, it’s a human reaction that leads to the conclusion that, because something has rarely or has never happened, it can’t happen this time around.

What makes normalcy bias dangerous is its effect on personal behavior.  When confronted with dire warnings, people’s responses tend to be binary:  either the affected person will rationally react to the warning (leave New Orleans before the hurricane), or due to normalcy bias, become complacent (try to ride out the storm because the last storm wasn’t so bad and the levees have never failed).

The problem with complacency is that it leads to blind spots, excesses, and is generally followed by sub-par performance.

Now, I’m no psychologist (although some accuse my writing as aptly characterized by the first 6 letters).  I don’t know why normalcy bias exists, considering it is a behavior so clearly detrimental to the safety of the biased individual.  It surely seems like something that should have evolved out of the human race a long time ago.  But it didn’t.  Nor did the complacency it creates.

While this blog post focuses primarily on complacency, I hope it simulates some thought as to whether the symptoms result from normalcy bias or they are simply a rational case of “letting the good times roll.”

Recently, we’re seeing a lot of evidence that complacency is on the rise.  To wit:

  •  NYSE short interest fell by 700 million shares over the final two weeks of 2012
  • NYSE margin debt is the highest it has been since February 2008 and is 22% higher than a year ago.
  • VIX (the “fear index”) is at its lowest level since May 2007
  • VIX has been falling on the same days the S&P 500 has been falling thus far in 2013
  • During the first week of 2013, individual investors:
    • Added $7.4 billion into emerging market funds.  This is the largest weekly inflow ever.
    • Added $8.9 billion into long-only equity funds.  This is the largest weekly inflow since 2004.
    • Added $22 billion into equity funds and ETF’s.  This is the largest weekly inflow since September 2007.
    • Individual investor sentiment is up:
      • 46.4% are bullish; only 26.9% are bearish.  These numbers average 39.0% and 30.5% respectively
      • 55% of American millionaires plan to increase their exposure to stocks in 2013.  This compares to 45% in 2010.

Many in the media have been touting these facts as evidence of a bull market ready to ramp upward.  Bloomberg recently praised the high levels of margin debt as “signs of increasing confidence after professional investors trailed the market since 2008.”

I guess one man’s sign of confidence is another man’s sign of investors chasing forgone returns.

When viewing the above-listed evidence of complacency, I see the fingerprint of normalcy bias.  The Fed has engineered a steadily rising market since early 2009.  Buying the dips has proven to be a profitable strategy.  Every.  Single.  Time.  When the market loses its footing, another round of QE picks it right back up.  The market was never negative on a year-to-date basis at any point in 2012.  The fiscal cliff was averted with no negative ramifications for stocks.

Why then should we be concerned about the geopolitics of Europe or the Middle East, the (likely) impending currency wars, the possible (probable) recession in 2013, the debt ceiling mess, increasing regulations, increasing taxes, increasing money supply, and increasing social stress?

These things are out there for all to see.

Like the repeated warnings in advance of a hurricane’s arrival.

But… not to worry.  We’ll ride out the storm because, after all, the levees haven’t broken in a really long time.