How “Recency Bias” Can Make You a Lazy Investor
Don’t assume today’s trend will last forever.
In this article, we’ll cover the recency bias, an effect that distorts our forecasts and makes investors complacent.
Author’s Note: This article is part of my series on investing psychology:
12 Common Mistakes That Can Destroy Your Investing Profits
Learn how successful investors avoid cognitive traps and build a winning mindset.
Recency Bias — What is it?
Recency bias is the tendency of investors to focus on recent trends and events, and unjustly assume they are more likely to happen in the future.
How does recency bias apply to investing?
When it comes to predicting stock market trends, recency bias is an investor’s worst enemy.
Human beings have a tendency to assume that whatever has been happening recently is more likely to continue happening, solely because it’s fresh in their mind.
For example, during bull markets investors have a tendency to feel like stocks will always go up. And during bear markets, they fear stocks will continuously go down.
Or, in the case of individual stocks, investors place too much weight on what recently happened when making investing decisions.
For example, if an investor buys a hot marijuana stock and then sells it for a 50% gain, he’s more likely to feel like marijuana stocks are going to be a good investment going forward.
Now, it’s possible that they could be a good investment. Or they could be a bad investment.
But that assessment shouldn’t be unfairly influenced by the recent memory of the investor’s sweet 50% gain.
Similarly, if an investor buys a banking stock and it declines by 20% in a month, he’s more likely to think banks are a bad investment. His evaluation of banking stocks has been unfairly colored by his recent experience.
But if he were to buy another banking stock and it went up by 80% in a week, he’d suddenly change his tune and start believing bank stocks make great investments!
Now, there’s some merit to the idea that recent trends have a tendency to continue. That’s the very basis of momentum investing.
And if we’ve been in a stable bull market for five years, a sudden 50% drop in stocks tomorrow is much less likely than more of the usual upward trend.
So the point isn’t to completely ignore recent data and trends.
The point is that our decision making can be too heavily influenced by what has recently happened.
And the reality is that various types of stocks and strategies tend to perform very differently each year. In other words, recent trends often change dramatically.
For example, look at this “periodic table of investment returns” from Callan:
It shows how several types of financial investments have performed each year.
And here’s another view from Novel Investor, which examines the performance of S&P 500 stocks by sector each year:
You can see that different investment classes and sectors shift up and down, from best to worst, and vice versa, each year.
In both cases, each investment strategy’s performance differs from year to year, often dramatically.
If you were to assume the most recent strong performers were going to be tomorrow’s strong performers, you’d almost always be disappointed.
What should you do instead?
To avoid recency bias, take a longer term point of view. Examine data and trends going back years, rather than just the most recent period.
“Am I placing too much weight on what has recently happened? Am I unfairly extrapolating a recent trend into the future?”
Another interesting question to ask is:
“Have I been investing during an era (for example, a long bull market) where I’ve come to assume certain things will continue forever (for example, that stocks will go up)?”
In other words, “Have I come to assume these conditions are now the new status quo?”
By framing your decisions using a longer time horizon, you’ll avoid the trap of assuming tomorrow will automatically look like today.
Disclaimer: This article is provided for informational or educational purposes only and is not any form of individualized advice. All information is obtained from sources believed to be reliable but cannot be guaranteed for accuracy or completeness. Use this information at your own risk.