Recency bias - could it be costing you?

In behavioural economics, recency bias is the natural tendency to make decisions based on recent events, with the expectation that those events will continue into the future.  

It causes us to assign greater weight to recent information while ignoring longer-term historical cycles. 

The bias is particularly powerful because it's 'hard-wired' into us, as we naturally have a better memory for information that we have recently received.  

Outside of investing, studies have shown that the recency bias is prevalent in employee performance reviews, where the final months of the year tend to carry the most weight as they are the most easily remembered. Also, a lawyer's closing arguments before a jury deliberates, are usually the most important as they are remembered the easiest. 

As investors, it's important to understand recency bias, as it can lead people away from carefully made investment plans, and towards trend-chasing and impulsive buying. 

A pin and a bubble 

Warren Buffett once wrote, "A pin lies in wait for every bubble, and when the two eventually meet, a new wave of investors learn some very old lessons." 

In the midst of the tech bubble in the late nineties, tech investors were focused on the recent past, which had seen tech stocks skyrocket in price, often by multiples. They believed that this recent performance would continue. However, over the next couple of years, most of these stocks went bust, costing investors all their gains and more. 

Another example is COVID. In early 2020, as the pandemic spread around the globe, some investors quickly bought up stocks that they believed would benefit from the pandemic. This included healthcare stocks and technology stocks such as Zoom Video Communications Inc. As more investors jumped on the bandwagon, stock prices were pushed to ridiculous heights. 

At the time, the 'recent past' showed a world in the grip of a pandemic, however, the future was always going to see a return to a more normal world. Eventually, this was realised, and the stocks came back down to earth, costing investors a fortune. 

More recently, when Russia launched its full-scale invasion of Ukraine in February 2022, there was an immediate spike in many commodities such as wheat and coal. However, this too eventually reversed, and prices returned to normal. 

Other more speculative investments such as Bitcoin or Gamestop, have also had their prices strongly influenced by recency bias. 

Booms and busts 

Recency bias also goes a long way to explaining market booms and busts.  

When investors see stock prices crashing, they may think that the falls will continue into the future, so they sell. On the flip side, if there's a bull market and everyone is making money, some investors may think the good times will roll on, so they buy. 

It is generally the case that in bull markets people aren't thinking about possible future bear markets, and in bear markets, people aren't thinking about possible future bull markets. 

So why do trending stocks or commodities often reverse in price? 

One reason is competition. When prices surge, others want to be part of the action, so new supply comes onto the market which dampens prices. 

There is also a natural move that sees these prices eventually revert to the mean. As Benjamin Graham wrote, "In the short run the market is a voting machine, and in the long run it is a weighing machine."  

Low interest rates 

Another example of recency bias is with interest rates. 

In 2021, after 30 years of low inflation and almost a decade of low interest rates, it could easily have been thought that low inflation and interest rates were here to stay. 

Even the then Reserve Bank of Australia governor, Philip Lowe (who was also possibly influenced by recency bias), said that interest rates would likely not rise until at least 2024. 

However, this was not to be, as inflation took hold, and the cash rate increased at its greatest pace on record, pushing many homeowners into mortgage stress. 

As you can see from the graphs below, the recent past is not a great predictor of the future. 

Six ways to overcome recency bias 

1. Study stock market history. Learn about the Great Depression, the GFC, and other major boom and bust cycles in our history. Understand that the stock market and economy are cyclical in nature, and though history doesn't repeat itself, it does rhyme. 

2. Have clear investment goals and stick to them through the good times and the bad. Avoid the latest trends and stick to long-term goals. 

3. Avoid buying stocks based on a tip or a gut feeling. Be aware that often the hot stocks of today are the duds of tomorrow. 

4. Remember the fundamentals. At times stocks can take on crazy values, so it's best to value them using reliable metrics. Also, ensure that any stocks you buy have excellent management with good track records. 

5. Diversify and invest long-term. Though this advice is often repeated, it is truly the best way to grow your wealth, 

6. Always keep yourself grounded. Never fall into overconfidence, as investment biases can impact both new and seasoned investors alike.