Recency Bias During Bull Markets
New investors who have been in the market for nearly a decade may have never seen a bear market. Additionally, many of folks who were investing in the last bear seem to have forgotten what one is like.
This is a phenomenon known as recency bias: the belief that recent events or circumstances have always existed and will remain forever. According to a BlackRock survey of retirement plan participants, 66% of surveyed workers believe that over the next decade, returns on their savings will continue to be in line with what they have experienced in the past, while 17% believe they will experience even higher returns. This shows how this type of bias can be particularly dangerous during periods of rising markets because it can grow stronger as the market reaches higher peaks. For example, a lengthy bull market can lull us into a false sense of security, which can translate into trouble – how do you think asset bubbles are created?
Recency Bias During Down Markets
Recency bias works the opposite way, too, when you experience negative events. In 2008, the economy was teetering on the precipice and the stock market crashed. Many investors quickly determined that these negative events would continue, and they liquidated their investment portfolios. When the financial markets rebounded, many of those same investors realized their error and jumped back into the markets. Unfortunately, they locked in their losses and bought back in after much of the recovery had already happened, costing those investors dearly.
That sort of perspective can cause irrational fear during bear markets, and it can also produce undue optimism and confidence during bull markets.
Avoiding Bias and Emotional Decision-Making
The last few years have seemed easy, but that doesn’t mean we should simply expect that to continue. We’ve already seen the return of some serious market volatility in the second half of 2018, so avoiding knee-jerk reactions due to bias or fear is crucial. Meet with your financial advisor, ensure that your long-term plan accounts for your level of risk tolerance and that your portfolio is well-diversified, and stick to the plan.
When emotions or recency bias become dominant factors in our decision making, the results are usually poor. We get greedy after good times in the markets, and fearful after bad times.
Timing bull and bear markets consistently simply does not work, which is why institutional investors use diversification as a core tenet of their investment strategies.
And if we get market timing even slightly wrong, it can be hugely damaging to long-term returns.
We are all susceptible to bias – such as following the herd and overconfidence in our own abilities. Utilizing a systematic, diversified investment strategy – and sticking to that long-term plan – is the best way to eliminate emotions and biases from our investments.