Avoid the trap of ‘Recency Bias’

What is Recency bias?

Recency Bias is the tendency of investors to take decisions based on recent events instead of long-term behavior of markets. Investors tend to extrapolate the situation and draw conclusions and they end up taking decisions merely on these conclusions.

Why does this happen?

Recency bias is basically an outcome of three cognitive behavioral biases:

• Availability Bias: People naturally take the information available to them and then try to make decisions based on that. The available negative covid news which our atmosphere is clogged with – easily hits the investor sentiments and compel them to react on it.

• Confirmation Bias: People often prefer things that justify their opinions. Say for instance, they prefer those news channels that represent their own views on politics, stock markets, etc. and avoid those that feature different opinions. People act similar when it comes to investing. An investor might have his or her own belief with respect to market conditions but people eventually tend to rely on those information sources that usually confirm their beliefs.

• Prospect Theory: Also said to be loss aversion, an investor feels more pain from losses than they feel happy with equal amount of gain. This behavior bias made investors extremely uncomfortable and created panic on the biggest market fall in the history.

Why this bias and extrapolation so dangerous?

This perpetual investor behavior, which leads them to exit equity when they are doing badly despite the fact their attractiveness goes up in terms of valuations after correction, but investors make a decision out of fear. So, if investors increase the cash/debt position at the cost of equity, the returns are unlikely to be in line with the market recovery.

Over the past 10 years, we went through a positive economic cycle after the great recession of late 2007-2009. Investors were doing well in the market. Now this has all shifted because of the coronavirus pandemic. During the financial crisis of 2007-2009, we saw people move out of the market and into safe investments. But when they stayed out, they ended up missing a 10-year bull market.

How to avoid the trap?

• Always try to work on what’s under control – Manage Asset Allocation. Perceive this major correction as an opportunity and not threat. Your advisor has already taken care of your contingency fund and near-term goals (If not, stop inflow to equity funds and do the same first). Now, invest the surplus money in the promising equity funds in a staggered manner. Be greedy when others are fearful.

• Don’t be swayed by latest performance of funds – Avoid extrapolating recent market returns. Currently, all equity funds are in deep negative and stock prices are fluctuating more because of investor sentiments than their fundamentals. And thus, we have seen good funds falling more than the funds performing poorly pre-covid situation. This alone should not convince you to switch funds. Consult your advisor and look at all the aspects.

• Don’t have a short sighted view – Focus on the bigger picture i.e. focus on your financial goals and long term wealth creation. Create investment pyramid and look at the bigger picture to cancel the unwanted noise and so-called experts around. It is always important to have a top-down view in place else just the bottom-up computations will make the portfolio lack cohesion and a clear strategy.

This will help you to avoid the trap and you will do better than the most of the investors who will still fall for recency bias no matter what, it’s in human DNA – And YOU have to avoid it!