Sometimes when we make investment decisions, we think we should try and predict the future. We want the best stock returns for a variety of reasons from things like retiring early or using the funds to purchase a new car. And if we are trying to predict the future, we’ll need a time machine for that. Assuming none of our readers have one – then it’s an impossible task. However, when humans are faced with difficult tasks, our brains often make short cuts and assumptions using recent events as a basis. This is called recency bias.
Humans tend to remember things that have happened more recently in our lives. This serves us well in very many situations, but in one aspect this doesn’t, is with personal finance. Recency bias can often make our decisions worse when investing. For example, if we see the market drop 10-20% or more within a short period of time, recency bias convinces us this will continue.
Recency bias and investing
A key insight from behavioral finance is recency bias and investors who base their investment decisions can get into trouble using it. Research suggests that recency bias encourages many retail and individual investors to use this strategy. A study that looked at trading decisions by individual investors of over 10,000 investors at large discount brokers found that they are swayed by recent events, and much to the investors’ detriment. The study found that investments bought by investors outperformed the market 40 percentage points over two years prior to purchase. While, the stocks that investors sold, outperformed the market, but not by a very large margin. The study says
“Many investors employ the simple heuristic of assuming that the recent past is indicative of what is to come. Selling is different. When selling, investors are concerned about what a stock has done prior to the sale (and since being purchased). In most cases, this leads investors to sell winners and hold losers”
Another example can be found with the 2008 market crash, another study found that during that period investors exhibited more recency bias. They used survey data and trading histories from investors during the crisis. The researchers found recent stock performance fueled investor trading habits and behaviors – that promoted them to trade more during the volatile time. Further, it showed that increased trading during the crisis hurt investors’ performance, it hurt their returns even after accounting for existing market volatility. These findings are also replicated in normal market conditions, researchers found that high trading levels resulted in lower than market returns for traders. Research of 66,465 households returned an average of 11.4% trading, while the market returned an average of 17.9 percent from 1991 to 1996.
How can we reduce our recency bias?
Before making any important decision, using the right information and resources are useful. This can be hard to do when the market is dropping or we just experienced a big gain. If we implement a few strategies right now to help with future events, this can be the following:
Looking at the full picture:
During a market crash or run up, we can look into the past and determine if our asset allocation is really what we desire. The chart below shows the real monthly US stock market returns going back to January 19886 and annual returns over the period of 1871-85. Each horizontal line represents the total cumulative wealth for that peak. Then it reconnects and moves above the prior line when the total wealth surpasses the past peak. Although, we can’t predict the future, in the past, the US market has rebounded.
Checking your risk tolerance:
It’s never a bad idea to check your risk tolerance at any point and certainly if the market has changed fundamentally, updating your risk tolerance to the new conditions is not a bad idea. However, make sure you are doing so because your risk tolerance has changed overall and not just because you’re facing a possible loss. If changing your risk tolerance in the mist of a market down turn, and it impacts your retirement plans or other goals, I’d recommend against changing your risk tolerance and holding true to your original plan.
Add friction to your decision:
Ever heard the phrase “Haste makes waste”? Well, it’s true in investing too. Logical and well thought out decisions are critical to a investors’ long-term goal. One way we can slow down our investment decisions is to calculate our taxes if we were to sell the positions right now. One study found that showing customers a tax preview of their holdings decreased their likelihood to sell by an average of 14% and for those with taxes over $5 it decreased their likelihood to sell by 62% compared to those who were not presented any info about their tax burden. Generally, sticking to your investment plan, is the best idea.
Explain the opposite position:
If you’re set on selling your investment. Try to explain to someone or just yourself why another person would be buying your investment. Is the other person experiencing recency bias too? Are they wanting to get in on the hot stock as well? Or are they seeing a hugely discounted offer and are picking it up for cheap? Forcing yourself to compare your decision with the alternative forces you to see your biases and reduce them.
When it comes to making investments during market volatility and sharp increases or decreases in price, we should remember that we are human. We all have inherent biases and often use intuitive thinking when we should be slow and methodical and use analytical thinking. Incorporating a frame work for when you wish to change your positions is a helpful way to prevent recency bias from impacting you.
Lastly, if you are trying to make better, more logical decisions regarding your personal finance YNAB is a great resource and getting started using a budget is a great starting point. But if you’re already past that and are trying to build wealth and want to invest, try using m1 finance (you’ll get an extra $10 dollars with the referral link) it’s a great platform for long term investing. It even lets you automate your investment so you don’t have to personally manage it, reducing your recency bias. And finally, if you’re looking for further ways to enhance returns check out our high risk and ultra-high risk newsletter.
Note: the m1 referral link gives the reader $10 extra dollars to invest with if they choose to fund a taxable with $100 dollars within 30 days of opening the account or fund an IRA with $500 within 30 days of opening an account. The author of this article will receive a $10 dollar compensation as a result of the reader opening an account. The compensation for both parties occurs 30 days after the deposit occurs and assumes the full amount is retained in the account until the end of 30 days from the deposit day. YNAB offers a free month of use this will be given to both the author and reader if the reader subscribes after the free trial period and buys a month of subscription. The author uses and endorses both YNAB and M1 Finance and both links are affiliate links.
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