If you let recency bias set the tone for your investment pattern, chances are you will always miss the big picture and end up making bad decisions for your investments
Consider these scenarios. A passenger is on a 10-day cruise. Over this duration, she spots six green and six blue boats from the deck of her ship. However, the green boats pass by more frequently towards the end of the cruise, while the blue boats were concentrated at the beginning. After the cruise, there is a high probability she will say the number of green boats was more than the blue boats.
Your sibling ordered Chinese thrice this month, over two weeks, and at the start of the month. However, over the past week, he ordered salad thrice. If you asked him what he has been eating this month, he would instinctively say that he has been indulging in salads.
What’s common? It’s called the Recency Bias. It is the tendency to remember and form an opinion on the most recently presented information. Simply put, we give more weight to recent events.
When 9/11 was still fresh in people’s memories, more Americans avoided planes and preferred driving instead. The memory of the recent catastrophe made the fear of flying weigh more heavily than it should have done. According to 2020 statistics presented by the National Safety Council in the US, these are some of the odds of death: heart disease (1 in 6), cancer (1 in 7), motor vehicle crash (1 in 101). As for passengers on an airplane, there were “too few deaths in 2020 to calculate odds”.
On a lighter note, I remember with amusement what my colleague once said about his little child. “When my three-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.”
This tendency to extrapolate our recent experience into the future comes naturally to us, and it is evident in all aspects of our life. Even investors are not excluded.
Unfortunately, when it comes to investing, this can have disastrous consequences, as 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 tend to forget about bear markets. As far as recent human memory is concerned, the market should keep going up, since it has been going up. Investors, therefore, keep buying stocks, feeling good about their prospects. When a bear market descends, falling stock prices can lead to panic selling, because the market “will keep falling, and never recover”.
Legendary investor Bob Farrell referred to this in a recent interview and explained it so well. “The longer a trend persists, the more people look at the trend as permanent. That’s why investors buy the most stocks or bonds at the peak in prices, and the least in the troughs.”
How Can We Control Its Impact?
Recency Bias occurs when we assume recent performance will equal future performance. Despite the disclaimers, our minds naturally want to project from the past. Here’s how to ensure that your mind doesn’t play tricks on you.
As Jason Zweig says in Your Money and Your Brain, it is human tendency to estimate probabilities not on the basis of long-term experience, but on a handful of latest outcomes. So, once you realise that whatever has happened most recently will largely determine what you think is most likely to happen next, look for logical explanations. Why do you think the market will rise forever? Why do you think we will never get out of the bear market? Forcing yourself to answer these questions will keep you grounded.
Markets grow as economies and corporate earnings grow. This trend has persisted through countless crises, and even now, markets are still driven by the same fundamentals.
Remember that reversion is the basic law of “financial physics”. Markets return to the mean over time. What goes up must go down. Price trends get overextended in one direction or another, but eventually return to their long-term average. In other words, extreme volatility is usually temporary.
Think of a pendulum. The further it swings to one side, the further it rebounds to the other.
This is nothing new. The India-Pakistan stand-off that brought both sides close to war (2001), the 9/11 Twin Towers attacks (2001), Iraq War (2003), US bombing of Syria (2017), North Korean Missile crisis (2017), the sharp deterioration in US-China relations (2020), and the recent India-China border tensions are few examples of these.
Geopolitical risks can refer to a wide range of issues (military conflicts, coups, climate change, Brexit). But they all create uncertainty and instil fear. The market’s short-term direction can change in a flash based on the latest headline. Don’t predict and gamble. Investors may try to predict the outcome of a geopolitical issue and guess its impact on investment markets, and invest, and end up losing ALL their money.
Money is not made by speculating and gambling away your savings. You have to understand the business, analyse the cash flows, and study the financials by watching how the management raises and deploys capital. Lastly, you must have the conviction to hold on during market upheavals. If you stick to your investment thesis, you will not get swayed by price swings and numbers. Always stay grounded in fundamentals, whether you are buying a stock or a fund.
The author is an Investment Specialist at Morningstar India