Recency bias is a nasty deceiver, but it can be avoided if you know what to look for.
As has become painfully obvious in recent weeks, bull markets don’t last forever. As 2020 began, the U.S. economy was chugging ahead at full steam, and stocks were posting new all-time highs. Many pundits expected the year to bring continued gains for both the economy and equity investors, even in the face of brewing trade troubles with China and geopolitical jitters in the Middle East.
The novel coronavirus (aka COVID-19) has since overshadowed all else, and we believe the global economy is headed for recession. The longest bull market in history officially came to an end in March, at times falling faster than at any point since the Great Depression of the 1930s.
The reversal has been stunning in scope and speed. And while the magnitude and pace of the drop are unusual by historical precedent, the decline itself is not. Bear markets are a normal part of every market cycle, and if you’re a long-term investor, you need to get comfortable with the concept that you can and will lose money in certain market environments. There was no way to know when this drop would happen, or what would cause it, but it was always inevitable that a bear market would occur.
To think otherwise is due to a psychological phenomenon known as recency bias. It’s a terribly sneaky trick our brains play on us, and it’s one of the primary culprits in preventing investors from achieving higher returns over time.
What is Recency Bias?
It’s natural to want to own what has done well recently, and on the flipside, to sell or avoid what hasn’t. This is why more and more individual investors tend to buy stocks the longer a bull market endures, often crowding into the largest and best-known names only after they have significantly appreciated (a good example in recent years is the so-called FAANG stocks, or Facebook, Apple, Amazon, Netflix, and Google). This follow-the-leader tendency is a direct result of recency bias, which is the unfounded conviction that recent trends will continue into the near-term future.
Recency bias works the same way in down markets. As stocks fell throughout 2008, trading volume intensified the worse the declines got. Investors rushed to exit losing positions, many of them locking in losses at or near the bottom. Then, convinced the declines would continue, far too many sat uninvested as the ensuing years gave birth to a new bull market and stocks renewed their upward climb.
Investors in 2020 face a situation similar to 2008. The underlying causes and market dynamics are completely different today, but the question is the same – get out and avoid more losses, or stay invested and hope to participate in a rebound?
The Right Way to Think About the Current Environment
The wrong way to answer this question is to guess about future market performance based on the last few weeks. The pain feels acute when because stocks are down, but this concept was just as true six months ago when stocks were high and rising – the most recent week, month, or even year is no basis whatsoever for predicting what will happen next.
What does matter are your goals and what you need the money for. Most investors are looking for at least some long-term growth, which means choosing investments based on what will be best for you in 10, or 20, or even 30 years. In that case, your decision has little to do with what happens this year or next. It is the next decade, or several decades, that matter.
If you are nearing retirement, you should be taking less risk with your overall asset allocation. That means holding less equity as a percent of your overall portfolio. It does not mean panic selling stocks because they are down. Unless you already have all the money you need for retirement, you’ll likely need to generate some growth in the coming years. That can’t be achieved with an all-cash allocation.
In both cases, the right answer is creating an investment strategy based on your specific goals, time horizon, and circumstances, and then sticking to it. Recent market movement, whether euphoria-inducing or gut-wrenching, is only there to tempt you into abandoning your plan.
Some Simple Steps to Help Prevent Recency Bias
Avoiding temptation is difficult for the best of us, but here are some additional tips to help keep you on track and avoid falling prey to recency bias.
- Seek an accurate picture of your financial assets and liabilities. Personal Capital’s free financial tools allow you to link all of your financial accounts, including your bank, investment, retirement, credit card accounts, and more to see all of your money in one place. Understanding exactly where you stand financially is a good first step to making sound portfolio decisions.
- Set achievable financial goals based on your long-term needs. A good way to track your long-term goals is the Personal Capital Retirement Planner. It’s an easy-to-use calculator that will help you project your portfolio’s ability to reach your retirement spending goals.
- Consider professional assistance. It can be hard not to react to the market – after all, this is your nest egg. A professional financial advisor who is a fiduciary (meaning they’re legally obligated to act in your best interest) can help you take emotions out of your investing decision-making.
Keeping recency bias out of your investment decisions is difficult, but it’s not impossible. The next time you’re tempted to buy because the market is up, or sell because it’s down, ask yourself if those actions align with your overarching strategy. In the long run, you’ll likely be much better off by sticking to a good plan and not attempting to time your way around market movements.