Investors often fall victim to the trap of “recency bias,” which refers to the tendency to give excessive importance to recent events, such as major stock market movements or the sudden rise of certain investments like bitcoin or meme stocks.
These short-term events often lead investors to make irrational decisions that go against their best interests, such as selling stocks in a panic. This bias can be detrimental to their financial well-being.
To better explain this concept, think of the irrational fear people experience after watching the movie “Jaws.” Despite the extremely low chance of being attacked by a shark, the fear of swimming in the ocean lingers. Similarly, recency bias causes investors to make decisions based on recent events rather than logical analysis.
According to Omar Aguilar, CEO and chief investment officer at Schwab Asset Management, it’s essential to recognize that recency bias is normal and hard-wired in our brains. Acknowledging this bias can help investors make more rational choices.
A real-world example of recency bias’s impact is the financial services sector’s performance in 2019. With a 32% annual return, it became a top-performing sector. Investors chasing this performance and heavily investing in financial services stocks were disappointed when the sector’s returns dropped by 2% in 2020, despite the overall positive 18% return of the S&P 500.
Other instances of recency bias include tilting a portfolio towards U.S. stocks after a period of underwhelming international stock performance and relying solely on a mutual fund’s recent performance to guide buying decisions.
Charlie Fitzgerald III, a founding member of Moisand Fitzgerald Tamayo, warns that recency bias can harm long-term results and impede clients from reaching their financial goals. Acting on fear, whether it’s fear of loss or the fear of missing out (FOMO), often leads to buying high and selling low, which is detrimental to investment outcomes.
Fitzgerald compares recency bias to a bee sting that lingers in our memory. Just as a bee sting can override logic and prevent us from approaching bees again, recent experiences can override rational thinking and influence investor behavior.
Investors are particularly vulnerable to recency bias when going through major life changes, such as retirement, as market fluctuations may seem more daunting during these transitional periods.
However, long-term investors can avoid succumbing to recency bias by maintaining a well-diversified portfolio. This type of portfolio includes exposure to various equity markets, foreign stocks, and potentially real estate. It also incorporates short- and intermediate-term bonds, as well as a small percentage of cash.
Investors can achieve broad market exposure by investing in low-cost index mutual funds or exchange-traded funds that track different market segments. Alternatively, they can opt for all-in-one funds like target-date funds or balanced funds.
Asset allocation, which determines the proportion of stocks and bonds in a portfolio, should be based on factors such as investment horizon, risk tolerance, and ability to take risks. For example, a young investor with several decades until retirement would likely allocate at least 80% to 90% of their portfolio to stocks.
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