Skydivers at the San Diego Convention Center.
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It’s “Shark Week,” the annual television-programming event on Discovery Channel that showcases the ocean’s apex predators. And there’s a valuable financial lesson that can be learned from the iconic man-eating great white shark featured in the 1975 thriller “Jaws.”
Investors often fall prey to “recency bias,” a cognitive bias in which recent events have a disproportionate influence on their decision-making. This bias, driven by fear or euphoria, can lead to financial losses.
Recency bias causes investors to give too much weight to recent events, such as stock market downturns or the meteoric rise of certain investments like Bitcoin or meme stocks like GameStop.
“It’s important for people to recognize that recency bias is a natural instinct,” explained Charlie Fitzgerald III, a certified financial planner based in Orlando, Florida. “It’s part of our survival mechanism.”
A person standing near a wild bear.
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However, allowing short-term emotions to guide long-term financial decisions is generally not in the best interest of investors. This behavior is similar to the illogical fear one might experience after watching the movie “Jaws” and being afraid of swimming in the ocean.
“After watching ‘Jaws,’ would you feel comfortable going for a long swim in the ocean? Probably not, even though the actual risk of a shark attack is extremely low,” wrote Omar Aguilar, CEO and chief investment officer at Schwab Asset Management.
Fitzgerald compared this impulse to the fear of getting stung by a bee.
“If I get stung by a bee once or twice, I’m not going back there again,” said Fitzgerald, a principal and founding member of Moisand Fitzgerald Tamayo. “Recent experiences can override logical thinking.”
Recency bias is often associated with FOMO
Here’s a real-world example:
In 2019, the financial services sector was a top performer in the S&P 500 Index, yielding a 32% annual return. Investors who chased this performance and heavily invested in financial services stocks may have been disappointed when the sector’s returns fell 2% in 2020, despite the S&P 500 having a positive 18% return, according to Aguilar.
People celebrating the release of the movie “Jaws.”
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Other examples of recency bias include shifting portfolio allocations heavily towards U.S. stocks after a period of underwhelming performance in international stocks, or relying too much on a mutual fund’s recent performance history when making investment decisions.
“Short-term market movements driven by recency bias can negatively impact long-term investment results, making it harder for clients to achieve their financial goals,” said Aguilar.
This concept often stems from a fear of loss or a fear of missing out (FOMO) based on market behavior, explained Fitzgerald.
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Acting on these impulses is similar to trying to time the market, which is generally not a wise strategy and often leads to buying high and selling low, he added.
Investors are particularly susceptible to recency bias when faced with major life changes, such as retirement, as market fluctuations may appear especially worrying.
The Benefits of a Well-Diversified Portfolio
Long-term investors with a well-diversified portfolio can have confidence in their ability to weather market storms instead of making hasty selling decisions.
A well-diversified portfolio typically includes exposure to different segments of the equity markets, such as large-cap, mid-cap, and small-cap stocks, as well as foreign stocks and potentially real estate. It also includes short- and intermediate-term bonds, and a small percentage of cash holdings.
Investors can achieve broad market exposure by investing in low-cost index mutual funds or exchange-traded funds that track these market segments. Alternatively, they can opt for all-in-one funds like target-date funds or balanced funds.
The appropriate asset allocation, or the distribution of stock and bond holdings, depends on factors such as investment time horizon, risk tolerance, and capacity for risk. For instance, a young investor with several decades until retirement would likely have a large portion of their portfolio allocated to stocks, typically around 80% to 90%.
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