Are memories of past market crashes clouding your judgment now? Or how about that HOT asset class! Don’t make any rash financial decisions. Financial Planner, Dave Duquette, shares the role recency bias can play in your investment strategy.
Recency bias is a cognitive bias that favors recent events over historic ones. When it comes to investing, this bias may lead you to think that a current stock market downturn or rally will continue.
Recency bias can lead investors to essentially panic and make short-term decisions that deviate from their overall financial goals. This mentality can quickly turn into irrational decisions, like following a ‘hot’ investment trend or selling traditionally well-performing stocks as soon as there’s a market downturn.
Remember: If you fail to plan, you plan to fail. We don’t recommend that clients deviate from their carefully laid-out investment plans as this can have long-lasting damaging impacts on your portfolio. Keep reading to see how to avoid recency bias in your investment strategy.
Key Takeaways
- With recency bias, people tend to put more emphasis on more recent events. Even if they are rare.
- Recency bias may lead investors to believe a current stock market downturn or rally will continue in the future. Market volatility happens and trends change over time.
- Don’t be short-sighted. Recency bias can make you change course from your long-term financial plans. Smart investing will look at empirical evidence.
- Partnering with a trusted Advisor can help you to plan for today and the future, while also reducing the negative impacts of recency bias on your portfolio.
What Recency Bias Looks Like in Investing Decisions
I get it, when making investment decisions, it seems like we’re predicting the future. But that’s an impossible task. Instead, we rely on evidence-based investing reviewing decade-by-decade returns - more on that later.
Recency bias means when we face uncertain times or market volatility, our minds are wired to think about our recent experiences (I’m sure you can remember last Friday better than January last year...). Recency bias in investing can convince you that a 10% drop in your portfolio is only going to lead to more financial losses. This fear causes some to deviate from their plan and sell/buy new stocks and ultimately do more harm than good for your financial future.
One study1 that looked at the trading decisions of individual investors found that their buying decisions seemed to be ‘swayed by the past returns of investments’. The investments bought by investors outperformed the market by 40% points over the two years prior to their purchase. However, in the long run, this strategy didn’t quite work out as the investors in the study thought. Researchers found that the stocks investors sold were outperformed by those they bought.
Resisting Recency Bias
Sadly, financial crisis (like that in 2008) leads many investors to experience the pitfalls of recency bias. Back then, researchers2 used survey data and trading records of investors and found that recent stock market performance fueled investor trading behavior--prompting them to trade more during that volatile time. These trades ultimately ended up hurting investors’ overall performance, surpassing the existing market volatility. These findings have also been replicated in normal market conditions.3
Clearly, our minds have a hard time looking past what is happening right now. To resist recency bias urges, we focus on managing relevant information, like the purpose of the account and remove emotions before making a decision. This focus in the face of market volatility can help make the best decision at the time.
Market Trends
Here are the data sources that compare The S&P 500 vs. International Value over 4 decades. There are plenty of market dimensions to compare here but we’ll focus on the S&P 500 vs. International stocks.
Imagine putting $100,000 into either the S&P 500 Index or the International Value index and holding for 10 years. It’s important to note that I would not recommend putting all of your money into one asset class but this will allow us to see how Recency Bias will often make people abandon a well-diversified strategy to move weight the “winning asset-class".
If you had a crystal ball and knew what asset class would be the best each year you would have had incredible results. If only we were clairvoyant...
Let's look at each decade from the 1980s – 2010s.
1980's - the S&P 500 (US Market) was out of favor compared to the International Market, specifically International Value (data above).
S&P 500 – 100k grew to $500k
International Value – 100k grew to ~945k
1990's - 100k in the S&P grew to roughly $530k while International Value 100k grew to 262k. By the end of the 90s, no one wants international compared to the S&P.
2000's - Known as the Lost Decade for the S&P. We had significant market events such as the tech bubble crash, Y2K, 9/11 from 2000-2002. And then the Great Recession of 2008. 100k in the S&P went to roughly 90k. 10% loss. While International Value 100k grew to 232k.
2010's - 100k in S&P 500 grew to 355k, the best asset class. International 100k grew to 170k. By the end of 2021 everyone believes that the S&P is the best place to have your money.
Most portfolios we review now a days are heavily over-weighted in US Large Cap stocks like the S&P Index.
Impulses Influencing Your Decisions? Slow Down.
Wait, don't move all your money! We’re only human, and our minds work so quickly that we may not realize how much it’s impacting our investment decisions. Even the most skilled investors can be swayed by recency bias. When it rears its head, lean on a trusted advisor and historical data that provides evidence to your best next move.
Remember: your portfolio isn’t something you should check and change daily; you’ll want to align it with your unique financial goals. Plus, some moves that recency bias compels you to make could have tax consequences (assuming a financial gain) too.
Prepare for Your Biases with a Professional
Past performance is no guarantee of future results.
During volatility, we're here to help you make thoughtful decisions when it comes to your finances. At Impact Medical Advisors, it’s our goal to help you avoid recency bias when it matters most – making drastic changes that will affect your financial future.
There’s a cost to chasing so-called ‘hot’ investment trends; often short-term market moves influenced by recency bias can reduce long-term results. Only making it more difficult for you to reach your financial goals. Watch for recency bias to avoid making irrational investment decisions.
ABOUT THE AUTHOR
Dave Duquette is the President of Impact Medical Advisors based in Tampa, Florida. As a part of Westshore Financial Group, he specializes working with medical professionals across the country. Impact Medical Advisors is guided by our mission ever in mind: to help people gain control of their finances.
DISCLAIMER
Financial images courtesy of Westshore Financial Proprietary information, and are for illustration purposes only.
Material discussed is meant for general informational purposes only and is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice. This material contains the opinions of the author but not necessarily those of PAS or Guardian. Individual disability income products underwritten and issued by Berkshire Life Insurance Company of America (BLICOA), Pittsfield, MA or provided by Guardian. BLICOA is a wholly owned stock subsidiary of and administrator for the Guardian Life Insurance Company of America (Guardian), New York, NY. Product provisions and availability may vary by state. Optional riders are available for an additional premium.
Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is a wholly owned subsidiary of Guardian. Impact Medical Advisors is not an affiliate or subsidiary of PAS or Guardian. CA Insurance License #0N14650. 2021-122189 (Exp. 6/23)
CITATIONS
1Brad M. Barber and Terrance Odean. The Behavior of Individual Investors, Updated: Jan 2012.
2Arvid O.I. Hoffmann, Thomas Post, and Joost M.E. Penning. Individual investor perceptions and behavior during the financial crisis, Available online: August 2012.
3Brad M. Barber and Terrance Odean. Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors, Published: December 2002.