The saying 'out with the old, in with the new' is often heard and can be beneficial for decluttering our homes. However, when applied to investing, it exemplifies recency bias.
This cognitive bias leads investors to place excessive weight on recent events and underestimate the significance of historical trends.
Recency bias originates from our natural propensity to use readily accessible information to predict future outcomes. Usually, the most recent news is the most vivid in our minds. However, in the world of investing, recent events don’t always forecast what lies ahead.
Recency bias can distort investment decisions. For instance, an investor may be tempted to purchase stocks in a bull market or sell in a bear market, assuming recent trends will continue. They might also pursue ‘trending’ investments based on their recent robust performance, disregarding the broader market context or long-term performance.
An illustrative example of recency bias occurred during the 2020 biotech boom. Investors heavily invested in biotech companies due to their recent successes, not fully considering whether these companies had sustainable business models. When the boom ended, those influenced by recency bias faced significant losses.
Adopting a disciplined, long-term investment strategy is key in counteracting this bias. Such a strategy emphasizes maintaining a diversified portfolio that aligns with an investor’s unique financial goals and risk tolerance, rather than reacting to recent market fluctuations.
Focusing on the present is part of human nature, recency bias can guide investors towards risky territory. By acknowledging this bias and employing strategies to mitigate it, investors can make more considered decisions.
