We have all been in a position where we are asked to recall something only to find we can only remember the most recent piece of information with the rest being a blur, such as attending a party with a group of people you have only just met when you can only remember the names of the last couple of people you were introduced to. This is known as the recency effect.
When making decisions, recency bias occurs when we put more weight on what has happened in the recent past whilst overlooking long-term data trends.
In some situations, this trait may be useful; for example, businesses that can react to immediate threats or opportunities can adapt and thrive, Covid being a recent time this has been put to the test. However, with investing, the opposite is true; being able to stick to a strategy over the long term and pay less attention to short term trends will often determine your success.
This article looks at how recency bias can lead to making poor investment decisions and what you can do to prevent it.
So how does placing too much significance on recent data lead to bad investment decisions? Over the short term, investment returns can be volatile. For example, a fund may have returned -10% this year and +1% the year prior, yet the long term data may show that over 20 years the fund has returned an of average 7% per year.
Recency bias will have us believe this is a poor investment, and we may choose instead to invest in what has performed well recently. But the recent performance data may cause us to pay less attention to the long term results, which might offer more reliable insight on whether the investment is sensible or not.
Research from Morningstar found that over the long term, there is no significant relationship between recent high performance leading to future high performance. You are just as likely to pick a higher-performing fund from what is currently underperforming compared to if you picked a fund from what is currently doing well.
Why Do We Get Caught Out?
Successful investing is as much, if not more, about the ability to manage our emotions in a way that we can stick to the strategy long term, rather than the actual strategy itself.
Unfortunately, emotions can get the better of us, causing us to focus on short term events. One example is fear of loss; during the steep market dip this year, many investors feared that after the initial drop, further drops would follow. Unfortunately, many pulled out of the market and held their money in cash, which may have seemed sensible at the time, but had they remained invested then they would have experienced much of the market recovery of recent months.
Also, when hearing in the media headlines about certain individual companies that are seemingly ‘going higher and higher’, fear of missing out can kick in. People are often inclined to ‘jump on the bandwagon’ thinking because it has done so well recently, it will continue to do so, but that sort of speculation can catch you out.
Is It Really Different This Time?
When a crash happens, expected or unexpected, the media will often portray the message that ‘this time it’s different’; that there is something about the conditions of the crisis or current geopolitical issue that means this time the impact is going to be even worse than ever before.
If we only focus on a crisis in isolation, recency bias will have us believe this narrative, which may lead to changing our investment strategy or withdrawing from the market altogether.
Instead, if we look at long-term data we can see that whilst each crisis or negative event may have a different origin and may have impacted the world in different ways, recovery has followed every single one thus far.
This suggests that you are better off staying in the market over the long term, which historically has given us more good years than bad years than you are in reacting to events in the short term or making decisions based on recent performance data.
But keeping your money invested in challenging times is easier said than done. What can we do to make sure we stay the course?
Start Out Right
Make sure your portfolio is right for you from the beginning; based on your personal attitude to risk and your individual circumstances. For example, if you are close to retirement and you are averse to risk, it would not be appropriate for you to hold a large portion of your portfolio in equities.
You have to be able to take the downs as well as the ups; it’s easy to favour a large amount of equities in your portfolio when markets have broadly been rising. But you have to then accept that if there is a dip in the market, you will experience the same proportional drop too.
Over time as the assets in your portfolio grow at different rates, the allocation in your portfolio can ‘drift’. For example, as equities typically grow at a higher rate than bonds, your portfolio value could be overweighted towards equities.
Your portfolio should be rebalanced periodically to ensure it stays in line with your risk profile and your investment goals over time.
If your portfolio is performing in a way that you are comfortable with, the likelihood of making a kneejerk response to short term market movements is reduced.
Pyrmont’s investment philosophy is built on evidence-based principles for what will determine long term investment success. We help you stick to your strategy over the long term by establishing a sensible strategy from the beginning and helping you make smart decisions along the way. If you feel you need help with getting started, get in touch today