How certain are you that tomorrow will be like yesterday? Is tomorrow more likely to resemble yesterday or last year? Most people would probably answer these questions with "quite certain" and "yesterday." That is the heart of what recency bias is: The phenomenon wherein people remember the recent past more easily than the distant past. Consequently, they are likely to overweigh the importance of recent events and deprioritize older ones.
This mental quirk is a natural function of the human brain and there is nothing wrong with it, per se, if you are aware of it. The danger, as with all cognitive biases, is assuming you are acting rationally, with no consideration for whether you may be giving undue importance to recent events. So how can recency bias adversely affect your investment performance?
It causes irrational exuberance
Why do late-stage bull market cycles tend to overrun economic fundamentals? After all, we all know the good times cannot continue indefinitely, and yet we are still shocked and disappointed when the bad times arrive. Bubbles have always existed - from tulips in 17th century Amsterdam to the dot-com bubble at the turn of the 21st century, we have ample evidence that the same pattern of frenzied buying reoccurs over and over.
Yet, SoftBank’s (TSE:9984, Financial) Masayoshi Son lost $130 million of his own money buying bitcoin near its all-time high in December 2017, as did countless other investors. In all of these cases, the tendency to assume the future would resemble the recent past, and that prices would increase indefinitely, led people to make these ill-fated choices.
It causes excessive conservatism
On the other hand, the recency bias is also what causes most investors to sit on their cash when the market is near lows. They assume prices will continue their downward slide and miss out on bargain basement prices. In a nutshell, recency bias is the reason why most people fail to follow Warren Buffett (Trades, Portfolio)’s famous adage: “be fearful when others are greedy and greedy when others are fearful.”
If you are older and have experienced several market cycles, you have the inherent benefit of knowing that trends to do not continue indefinitely. You must, however, make sure you learn from this experience, positioning yourself accordingly the next time around.
For younger investors, financial history should be your teacher. Using the historical record should go some way toward helping you identify recency bias in yourself. Try to view the situation abstracted away from recent history and just ask yourself: “Are stocks cheap on an absolute basis?” Don’t get sucked in by the trend.
Disclosure: The author owns no stocks mentioned.
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