Most of us have seen some form of the disclosure, “Past performance is not necessarily indicative of future results.” Many investors, however, fail to take it to heart when making decisions about their investment strategy.
This effect is common enough that is has its own name: Recency bias. Recency bias is the tendency to think that trends and patterns in the recent past will continue in the future, which then impacts certain conclusions, decisions or behaviors. From an investment perspective, this means you may be letting the euphoria of the long-running bull market influence your investment decisions too much.
How Can Recency Bias Impact Your Portfolio?
This bias can be particularly dangerous during periods of rising markets because it can grow stronger as the market reaches higher peaks. For example, today’s bull market celebrated its eighth birthday a few months ago, making it one of the longest running rising markets in history. This lengthy run helps lull us into a false sense of security, which can translate into trouble – how do you think asset bubbles are created?
The dotcom bubble before the turn of the century saw the NASDAQ index increase from below 1,000 to more than 5,000 during a five-year period, as investors poured money into anything with a “.com” attached to its name. 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. Recency bias cost those investors a lot.
When is Recency Bias Most Dangerous?
If you are nearing retirement, wearing recency-bias-colored glasses can be especially dangerous. For example, if you’ve put together a substantial nest egg and you’re thinking of retiring in a couple of years, don’t let the returns of the past few years lead you to take on more risk. You may think boosting your savings could mean more luxurious choices when you finally leave the rat race, but it could actually lead to more damage than good. What happens to your investments immediately before and/or immediately after you retire have much more impact on your overall lifestyle than events that happen considerably before or after you retire.
Tips to Prevent Recency Bias from Harming Your portfolio
Since recency bias is a natural human tendency, how can you avoid being tricked by your own brain? Here are some tips to keep this bias in check, including:
- Seek an accurate picture of your financial assets and liabilities
- Establish achievable financial goals aimed at your long-term needs
- Identify and prioritize your risk tolerance levels and stick to your long-term plan vs. short-term trends
- Determine how much time you have to save to reach your goals
- Find appropriate professional assistance to help keep you on track
Keeping these tips in mind means you may minimize your impulse-based decisions, which is a good start. Then, in the words of Odysseus, “put wax in your ears – tie yourself to the mast if you must — and ignore the bull market’s Sirens song”. Don’t let recency bias guide you into the rocks when it comes to your investments and make sure to stay focused on your long-term goals.