Recency Bias: Why Past Investment Wins Can Lead to Future Losses

Recency bias, a common pitfall in the world of investing, is our tendency to overweight recent events and information while underestimating long-term trends or historical data. In simpler terms, we tend to believe that what has happened recently will continue to happen, and we let this short-term view unduly influence our decisions. This bias is particularly potent in financial markets, driving investors to “chase recent performance,” a strategy that often leads to disappointing results.

So, how exactly does recency bias cause investors to chase recent performance? Imagine this scenario: a particular sector, let’s say technology stocks, has experienced a significant bull run over the past year. News headlines are filled with stories of soaring tech company valuations and investors reaping substantial returns. Fueled by recency bias, many investors start to believe that this upward trend is the new normal. They see the recent gains as a strong indicator of future success and become convinced that technology stocks are the only path to quick and substantial profits.

This belief, driven by the vivid and recent memory of rising prices, overshadows the longer-term perspective. Investors might forget or downplay the inherent cyclical nature of markets, the potential for corrections, or the importance of diversification. They might overlook historical data showing that no asset class outperforms consistently forever and that periods of high growth are often followed by periods of consolidation or even decline.

Consequently, swayed by recency bias, these investors begin to “chase performance.” They pour money into technology stocks, hoping to capture more of the recent gains. This influx of capital further drives up the prices of these stocks, creating a self-reinforcing cycle. It feels like a sure thing because “everyone is doing it” and “it’s been working so well lately.” However, this is precisely when the risk increases. Valuations become stretched, and the market becomes increasingly vulnerable to a correction.

The problem with chasing recent performance is that it’s essentially buying high. By the time a trend is clearly visible and widely reported, much of the potential upside may already be realized. When investors pile in based on recent performance, they are often entering the market near its peak. When the market inevitably corrects, as markets always do, these latecomers are often the hardest hit. They bought at inflated prices, and when the trend reverses, they are left holding assets that have declined in value.

Consider the opposite scenario. Imagine a sector, like emerging markets, has underperformed for a few years. News headlines are less enthusiastic, and investors are generally wary. Recency bias would lead many investors to avoid emerging markets, assuming the underperformance will continue. They might miss the opportunity to buy into these markets at potentially undervalued prices, just before a potential turnaround.

Recency bias is rooted in our natural human psychology. Our brains are wired to pay more attention to recent and readily available information. It’s a cognitive shortcut that can be helpful in everyday life but can be detrimental in investing. We are more likely to remember and be influenced by the exciting story of a friend who made a fortune in a recent stock surge than by the less exciting, but more statistically relevant, long-term average returns of a diversified portfolio.

To combat recency bias, investors need to cultivate a more disciplined and long-term approach. This involves:

• Focusing on Long-Term Goals: Remind yourself of your long-term financial objectives and create an investment plan that aligns with those goals, rather than reacting to short-term market fluctuations.
• Diversification: Maintain a well-diversified portfolio across different asset classes, sectors, and geographies. This reduces your reliance on any single area of the market and mitigates the risk of being overly exposed to a trend that might reverse.
• Historical Perspective: Study market history to understand that cycles of booms and busts are normal. Realize that recent performance, whether good or bad, is not necessarily indicative of future returns.
• Disciplined Investment Strategy: Stick to a pre-determined investment strategy and rebalancing schedule. Avoid making impulsive decisions based on recent market noise or emotional reactions to short-term performance.
• Seek Objective Advice: Consult with a financial advisor who can provide objective guidance and help you stay grounded in your long-term plan, rather than being swayed by recency bias.

By understanding recency bias and actively working to mitigate its influence, investors can make more rational and informed decisions, ultimately increasing their chances of achieving their long-term financial goals and avoiding the pitfalls of chasing fleeting market trends.