Imagine you are driving in a foreign country for the first time. On your drive you pass an equal number of red and blue cars, but you see most of the blue cars at the end of the journey. If so, you’re likely to think there are more blue than red cars on the road.
That’s “recency bias” – our tendency to rely on recent experiences more than on distant ones when predicting what will happen in future.
Getting the apparent preference of drivers for blue cars wrong will have no consequences except for the car manufacturer who gets his order wrong. However, when it comes to investing, recency bias can prove very costly indeed.
When markets are rising
If the market has risen, we assume it will continue rising. Many of us will also keep looking at our rapidly rising portfolio values and may buy ever-more risky assets. Because of our inherent recency bias, we can forget that markets can also fall and become overly optimistic, possibly just as markets move into over-valued territory. The dotcom bubble and subsequent crash of the late 1990s was one classic example of this behaviour, resulting in devastating losses for many investors.
When markets are falling
But recency bias doesn’t just occur in rising markets. When markets are turbulent, stock markets can make negative headlines on a daily basis.
Although share prices may have already fallen considerably, many investors might assume that the downward trend will continue and seek shelter by selling up. But in the past, markets have tended to recover eventually. Those who sell often realise losses and risk missing the right time to re-enter the market.
How to combat the recency bias
Age and experience can be a real advantage when it comes to overcoming recency bias. Those who invested through the dot-com boom, global financial crisis of 2007-08 and Covid-19 pandemic had the opportunity to learn valuable lessons: Neither market upswings nor downturns last forever, and markets are full of surprises.
If you’ve only recently started to invest, remember to take a long look in their rear-view mirror whenever you find yourself getting complacent during a bull market or are all too pessimistic during a bear market.
Tuning out the noise and remaining disciplined in your investment strategy and financial plan is a great way to offset the tendency to overestimate the significance of recent events.
Investment risk information
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