Don't expect the stock market to continue current path

Recency effect is the tendency to remember a more recent experience better than a previous experience.

Behavioral economists call this recency effect "availability" and it is programmed into our DNA: I touch a hot stove — ouch!; I learn not to touch a hot stove again. Eventually I use the contained flame to my advantage, to prepare meals for my nourishment. But the result of touching the stove and getting burned is still stored in my memory, inspiring me to use a hot pad and keep my hands well away from the heat.

For investors, recency effect can bias investing decisions based on recent market performance. Whether up or down, we tend to extrapolate the recent event into the future. If the market is going up, we are more likely to act on expectations of a rising market. The converse is also true. Both tendencies can be dangerous.

As long-term investors, we want to look past short-term volatility and contain the effects of recency. To do so is difficult because we are always wary of getting burned. And as many of us know, getting burned can hurt. Think 2008 when the market was down almost 32 percent, or Black Monday in October 1987, when the market was down 22.6 percent in one day, or even the past few weeks.

Our instincts encourage us to run for cover in the face of danger. Yet savvy investors know that treacherous times also present opportunities: Including 1987 and through 2013, the market is up an average of 11.1 percent per year.

During volatile markets, you should rely on a valuation benchmark. In previous columns we have talked about the price-to-earnings ratio, which provides us with a common measure of value. The p/e ratio tells us what we are paying for a company's future earnings. Like the price-per-square foot when we buy a home, the p/e supplies a standard of measure that lends perspective.

So what is the p/e ratio telling us about the relative value of the S&P 500 after October's sell-off? At the beginning of October, the p/e (based on forward earnings) was 15.5x, in line with the historical median.

Friday, after three volatile downward weeks, the forward p/e is 14.6x, or about 10 percent lower than the historical average p/e. If the markets are not in an official correction, they are close — hovering about 10 percent below historical fair value for stocks.

Corporate earnings reports this week may potentially disappoint and roil stocks further. Look for great companies selling at a discount. If you find one that meets your objectives, take a nibble. Kim Forrest, senior equity analyst at Fort Pitt Capital Group, quipped, "People who thought they had risk tolerance are finding out they don't."

Recency effect keeps investors from the doing the right thing for the long term in both up and down markets. Contain the flame and stick to your discipline.

Nancy Tengler spent two decades as a professional investor. She is an author, financial-news commentator and university professor. Her book, "The Women's Guide to Successful Investing," is out now. Reach her at nancy.tengler@cox.net.