As humans, we have an easier time remembering what happened most recently.
For example, you are driving in a new city. You pass an equal number of red and blue cars, but most of the blue cars are spotted at the end of your journey. Studies suggest you’re more likely to think there are more blue cars than red cars on the road.
This happens because we have a tendency to extrapolate our recent experience into the future. Placing undue importance on recent events is called the Recency Bias. This is why when we see our portfolio drop 10%, we somehow believe that it will just keep on dropping.
Samantha Lamas, a behavioural researcher at Morningstar, explains why this thought process can mess up with our portfolios.
In a study that looked at the trading decisions of individual investors at a large national discount broker and a large retail broker, researchers found that investors’ buying decisions seemed to be swayed by the past returns of investments. The investments bought by investors outperformed the market by 40% over the two years prior to their purchase. In the long run, this strategy didn’t quite work out for the investors in the study. Researchers found that the stocks investors sold subsequently outperformed those they bought in the ensuing months.
Interventions to combat recency bias can be organized in two different approaches: one focused on managing relevant information and the other on slowing down the decision-making process.
Half the battle is won if you recognise that this human tendency exists. And any investor can fall prey to it. Any – irrespective of age, gender, nationality or race.
Whatever has happened most recently will largely determine what you think is most likely to happen next – even if, in reality, there’s no logical reason to assume that the recent past will have any impact on the future. Jason Zweig in Your Money and Your Brain
- Filter out the noise to focus on what’s important
Before making any important decisions, surrounding yourself with the right information and resources is essential, but that can be hard to do during volatility. When the market is dropping, our minds have a hard time looking past what is happening right now.
Talk to your financial adviser during such periods. Reconnect with your goals. Also, look at past returns. No investment or fund performs spectacularly year after year.
During a market crash, it can be difficult to remember that market declines are fairly regular occurrences. Researchers recently tracked market crashes over nearly 150 years in the U.S., and found that they occurred about every nine years. Paying attention to such information during volatility can help us remember that, while the market's road can be bumpy for investors, it’s a ride worth taking. Although we can’t predict the future, the market has eventually rebounded in the past.
Ditto when the market is on a roll. We assume it will just climb higher and buying at any valuations should not matter.
- Set an information schedule
Receiving constant market updates can sway even the most skilled investor. During times of market volatility, try setting a schedule for how often you check your portfolio and the news. Once you make sure your portfolio is aligned with your goals, try checking it only once a quarter (and stick to this schedule even when markets have gone awry). When it comes to catching up with recent events, try checking the news once at the end of the day, or even just once a week.
Recency bias is a tricky one to spot because our minds work so quickly, and we often don’t notice just how much we are being swayed by recent events. During times like these, it can help to slow down the decision-making process to give our conscious mind more time to evaluate.
- Add friction to the decision
Before making a hasty decision, calculate the tax consequences (assuming you’re still facing a gain) or transaction fees of the proposed trade. Many investors hate paying taxes even more than they dislike the prospect of losing value in a further market downturn.
To avoid a hasty decision, try setting up decision-making "speed bumps." A speed bump could be a 3-day wait rule where you can't act on a decision for this period. You could also decide that a trusted friend or partner has to sign off on a decision before you take action. This can help you take a step back from your emotions and make time to think.
Be your own devil’s advocate.
If you’re set on selling an investment, try to explain why a person might be willing to buy your securities. What might a person’s reaction be when your investment pops up on their screen at such a discounted price? If you were in their shoes, what might you do?
Forcing yourself to answer questions like these before making investing decisions can help you see past your biases.
Our minds have an easier time remembering and noticing facts and ideas that support our opinions. Allowing for a different perspective before acting can reveal every angle of a decision. Using this technique can also help when you're sifting through information online. If you keep coming across evidence that supports your opinion, challenge yourself to seek out credible information that convincingly shows the counter opinion.
We are only human. We all have biases that can lead us astray when making investing decisions. Incorporating a more thoughtful decision-making process may help you avoid falling prey to your biases when it matters most.
