Consider these scenarios.
A passenger on the observation deck of a cruise ship spots precisely equal numbers of green boats and blue boats over the duration of her trip. However, the green boats pass by more frequently toward the end of the cruise while the passing of blue boats were concentrated toward the beginning. Following the cruise, there is a high probability that the recency bias could influence the passenger to recall that more green than blue boats sailed by.
You’re driving in a new city. You pass an equal number of red and blue cars, but most of the blue cars are spotted at the end of your journey. Studies suggest you’re more likely to think there are more blue cars than red cars on the road.
In a November 2017 post, Ben Johnson, Morningstar’s director of Global ETF Research, commented: When my 3-year old throws a tantrum, I tend to picture her as a grown woman kicking and screaming on the floor, even though I’m confident she’ll become a well-adjusted adult.
Recency bias describes our tendency to extrapolate our recent experience into the future. Investors do the same. And when it comes to investing, this can have disastrous consequences. Because it skews our view of reality and the future. What happened yesterday, might not necessarily happen again today, let alone tomorrow.
During a bull market, people inadvertently tend to forget about bear markets. As far as human recent memory is concerned, the market should keep going up since it has been going up recently. Investors therefore keep buying stocks, feeling good about their prospects. When a bear market descends, falling stock prices can lead to panic selling, because hey, the market “will keep falling and never recover”.
In that same post, Ben Johnson speaks of an investment mistake that can be partly attributed to recency bias.
In 2009, he bought shares of the paint, coatings, and chemicals manufacturer PPG Industries. This was a highly cash-generative company that had consistently raised its dividend for decades and was in good financial health. But the market was near its nadir and the company was clearly going through a rough patch. Looking at it from a contrarian and value-oriented strategy, he acted on this once-in-a-lifetime buying opportunity.
From his date of purchase (February 20, 2009) to the end of October 2017, the stock returned 27.6% annualized, as against 17% of the SPDR S&P 500 ETF.
Before you go wow, Ben notes that he missed out on the rally. One month after buying, he sold his shares. Why? At the time, it seemed like the world was ending, that the market—and maybe even the global economy—had more pain in store. Recency bias got the best of him. His opportunity cost was greater still, as his recency bias led me to leave the proceeds of that sale in cash for years afterward.
How can we try to control recency bias?
Half the battle is won if you recognise that it exists. And any investor can fall prey to it. Any – irrespective of age, gender, nationality or race.
It is human tendency to estimate probabilities not on the basis of long-term experience but rather on a handful of the latest outcomes.
Whatever has happened most recently will largely determine what you think is most likely to happen next – even if, in reality, there’s no logical reason to assume that the recent past will have any impact on the future.
- Jason Zweig in Your Money and Your Brain
- Don’t have a myopic view.
Get a grasp on the long-term trend in the market. Gut-wrenching falls notwithstanding, it has been positive. Markets grow as economies grow as corporate earnings grow. This trend has persisted through countless crises. Despite all upheavals, markets are still driven by the same fundamentals.
- Work with what is in your control.
Control your asset allocation. Stay diversified. Invest in the right instruments taking into account the investment tenure. Set realistic expectations. Comprehend the risk you can take. Try to minimize taxes. Have a sound buying thesis.
- Don’t get swayed by the latest performance numbers, however good.
Always stay grounded in fundamentals, whether buying a stock or a fund. Be aware of the role it has in your portfolio. Steve Wendel, head of behavioural science at Morningstar, says that the recency bias happens when we assume recent performance equals future performance. Despite the disclaimers, our minds naturally want to project from the past. Sometimes that’s real (momentum), and sometimes it is just a trick of the mind. We’re not good at telling the two apart.
- Remember that cyclicality comes with the terrain.
Pay attention to the cyclical nature of asset class returns, securities or asset groups. No investment or fund performs spectacularly year after year. You will be vulnerable to a downdraft, but if you have invested based on a solid thesis, and it still holds, the downturn will in most cases be just temporary.
Remember reversion to mean, the basic law of “financial physics”. What goes up must go down, and what goes up the most usually goes down the most.
Find appropriate professional assistance. The services of a financial adviser are extremely essential to help you stay grounded.
Also read:
Investment involves risk of loss
