As we stated last week, we’ll spend some time discussing behavioral finance throughout the year. This week, the focus will be on recency bias, which is particularly important to understand after such a tough year. Recency bias is a cognitive error identified in behavioral economics whereby people incorrectly give more weight to recent events, believing they will occur again soon. This tendency is irrational, obscuring the actual or objective probabilities of events occurring and leading people to make poor decisions.
This bias can be particularly detrimental in investing. One of the most common examples of recency bias in investing is the tendency for investors to chase performance. When a stock has recently performed well, it is tempting to buy more, even when overvalued. Conversely, when a stock has performed poorly, investors may be inclined to avoid it, even if it presents a good buying opportunity.
Recency bias can also lead investors to make decisions based on recent market events. During a market downturn, investors may become overly pessimistic and sell their investments, even if they have a long-term investment horizon. Focusing too much on recent events can be particularly painful when markets are correcting, as reactive and short-sighted allocation decisions will impact future return potential.
To avoid recency bias, focusing on the fundamentals of a stock or market and having a long-term investment plan is essential. It is also important to remember that past performance is not necessarily indicative of future results. With this in mind, maintaining a diversified portfolio can mitigate the impact of recency bias while reducing the overall risk of your investments.
Outside of investing, recency bias occurs in other areas, such as personal decisions, politics, and healthcare. Avoiding recency bias in decision-making is imperative. Taking a step back, looking at the bigger picture, and considering long-term consequences rather than short-term implications are crucial.
By understanding and recognizing recency bias, individuals can take steps to avoid it and make more informed, rational decisions. In the context of investing, this means focusing on fundamentals, having a long-term plan, and diversifying your portfolio.