How Recency bias affects investors

One of the key behavioural trait that effects investing is called Recency Bias. Recency bias is a trait that an investor exhibits by giving greater importance to recent events or results when compared to the past events or results. It is a tendency of investors to extrapolate recent trends (both favourable or unfavourable trends) indefinitely into the future. Giving overdue importance to the recent trends while ignoring the historical trends can result in unintended consequences in investing.

Most investors try to take investment decisions on what they think will happen in the future but usually those decisions are based on the conclusions that are reached by extrapolating only the recent events into the future. Investors have a tendency to think that in a bull market, the market trend would continue to remain bullish and vice versa in a bear market.

This phenomenon has been seen in all the asset classes such as Stocks, Mutual Funds, Real estate, Gold etc. Investors tend to invest in asset classes that have performed well recently and they tend to stay away from the asset classes that have not been performing well.

Most of the investors extrapolate the bad performance of the economy or the asset class and they also tend to extrapolate the good performance of the economy or the asset class. This also explains why most of the investors tend to buy assets such as Equity, Mutual Funds, Real estate, Gold etc. at higher prices, when the recent performance is good rather than at lower prices when the recent performance is bad.

For example: Till 2013 investors have been investing in Gold and Real estate as the performance of these asset classes was better than equities, but offlate the performance of these asset classes is muted, while the performance of equities has improved. This illustrates the fact that the past performance is no guarantee for the future performance and investors should avoid investing decisions just based on the recent performance.

The recency bias phenomenon is clearly visible in the stock markets, where though the cycles of the booms and busts occur regularly, the number of investors who invest near the market peak when the prices are high, are more, compared to the number of investors who invest at the market bottom when prices are low, as investors extrapolate both the good times and bad times to continue in Future.

It is always advisable for investors not to get carried away by the recent trends and to act taking into account the historical context as well i.e., looking at the bigger picture. Impulsive decisions based on only the recent developments can negatively impact the long term investment performance.

Successful investors are aware that the asset classes tend to go through the cycles of few years of outperformance and few years of underperformance. They also know that they should not get swayed by the recent outperformance while investing and likewise disheartened with the recent underperformance. In fact, they take advantage of recency bias of other investors to attain attractive long term returns on the overall portfolio.

Investors should avoid focusing on just the recent performance and take a short term view instead they should focus on the big picture and take a long term view of the investment prospects, while investing.

One thought on “How Recency bias affects investors”

  1. Well said.. People often get carried away with myths and still does not come out of the shell that stock market investment is a bullish thing and prefer to play safe with guaranteed things. Playing smart is a universal phenomonon and is applicable for all types of investments.

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