As investors it is difficult to detach emotion from our investing decisions.
Behavioral finance explores how many common biases prevent us from thinking objectively about financial decisions.
In today’s installment we review recency bias, the tendency to place too much emphasis on recent events in our decision making.
Imagine playing a game where you must guess if a coin will come up heads or tails. It is a fair coin with equal chance of coming up either side. You flip the coin and watch it come up heads four times in a row! How does that affect your prediction of what the next flip will be? Think about it.
I’ll bet that you either thought “it has to be tails this time, it can’t possibly come up heads 5 times in a row.” Or maybe you took the other side, “heads can’t lose, I am guessing heads this time for sure!”
In reality we know the answer. No matter what any of the previous coin flip results were there is a 50% chance of coming up heads and a 50% chance of coming up tails even though our observation of recent events wants us to believe differently.
With investing, much like a coin flip, recency bias can lead us to believe that recent events in the markets will continue into the future. Just like with the coin flip, it can cause us to overweight short-term observations and undervalue long-term patterns, historical data, and objective analysis.
What are some ways I’ve seen recency bias present itself lately?
1. Investor willingness to take on more risk than they can handle in up markets
As advisors a key job of ours is to help clients define the appropriate risk for their investment portfolio. Too much risk can lead to large losses in a down market and the client abandoning their investment portfolio, often right at the bottom when the losses are deepest. Too little risk and the portfolio may not produce enough return to meet the client’s planning objectives.
Unfortunately, when markets have a prolonged steady run up, another emotional bias – Fear of Missing Out (FOMO) sets in and may cause an investor to over-extend the riskiness of their portfolio. The result? Much steeper losses when the market corrects itself. Here, it helps to ask yourself questions like “what if I woke up tomorrow with only 50% of my portfolio?” Quantify that amount in dollars, not just as a percentage. Also, stick to your investment policy statement – a definition of risk that gets put in place before the market gets volatile and emotion sets in. Don’t have an investment policy statement? Reach out to an advisor who can help you put one in place.
2. Loading up on technology and “work from home” companies
The market roared back after the sharp drop in the markets in March of 2020, led by technology and especially stocks that played into life in quarantine and working from home. For example Zoom (ZM) and Docusign (DOCU) had meteoric rises in 2020 and even led to the creation of at least one work from home exchange traded fund – the Direxion Work From Home ETF (WFH). Is that an indication to build your 2021 portfolio around work from home companies?
Don’t let recency bias cause you to ignore other corners of the market. While these companies should be in any diversified portfolio, many have lagged the market as a whole in the first quarter of 2021. Growth companies have underperformed the market so far this year, and a diversified portfolio that included some of last year’s underperformers would have helped combat this.
3. Concentration in U.S. investments and ignoring international investments
It’s true that US investments have generally outperformed international investments since the great recession. Recency bias has crept in and as a result and many portfolios come across my desk with little or no international investment exposure. Is the assumption that, because the last decade has been better for U.S. investments, the next decade will be as well?
Similar to the work from home story above, we don’t know when the pendulum will swing back the other way, but we want to be there before it does. If you were an investor before the great recession, you may remember international leading the way from 2003 – 2007. I remember many investors, displaying their recency bias, buying into international funds well after those funds had already seen big gains. Positioning your portfolio now to include some allocation to non-U.S. investments means you won’t have to chase performance, and you won’t have FOMO either.
Investment portfolios are very personal and are created to accomplish specific goals for each investor. Make sure you speak with an advisor to review what is appropriate for your portfolio before taking any action. One thing I am certain should not be in your portfolio though is recency bias. An objective, second set of eyes can help take the emotion out of your investing decisions.
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