Is Recency Bias Hurting your Investment Performance?

Carla Fried

I don’t need to be an ophthalmologist to tell you you’re probably short-sighted when it comes to how you handle money.  And your outlook can cost you plenty.

Researchers have found that when it comes to making financial decisions we all tend to focus intently on events or information that are right in front of us rather than take the long and wide view. We overweight information from this week, or last month far more than the cumulative information across years and decades. Among behavioral economists - the folks who study the mind games that shape our attitudes and actions with money - this is known as recency bias. That is, whatever is most recent in our experience is what lords over our current actions.

And that bias can play nasty tricks on our financial decision making skills. For example, in good times (see: Internet bubble circa 1999) the tendency was to get so caught up in the outsize gains within the technology sector that you, um, may have forgotten about the basic rules of diversification and let your portfolio become way too overweight with high-growth tech stocks.

Of course, just the opposite may be at play these days. In the wake of the financial crisis and the deep bear market, investors bailed out of stocks and piled into bonds, missing out on the sharp stock market rebound that began in March 2009

How to Fight Your Recency Bias:

·   Process information. I am not one to suggest you completely tune out what is going on in the world. That seems a bit too simplistic. But what many of us can do a better job of is not immediately reacting – or often overreacting - to news. Sometimes the best action is no action.

·   Think mean. Regression to the mean, that is. The mean is the long-term historical average for a piece of data; whether it is mortgage rates, or the return of the S&P 500. When you see something that is wildly off its historical mean, you should be considering that the odds are that it will at some point - and the timing is unknown - revert to its mean. A lot of money has been lost through the decades and centuries betting that “this time is different.” It usually isn’t. We tend to circle back to long-term trends. So if something is abnormally cheap today, it may be less cheap in the future. If something is abnormally expensive today it will probably become less expensive in the future. Regression to the mean is a good concept to use as a constant reference point.

·   Rebalance. Okay, I know it’s not exactly sexy advice, but it is the single best way to make sure you don’t become too optimistic or pessimistic with your investments based on recent events. Check back in on your IRA and 401(k) at least once a year and make sure your overall asset allocation is still in sync with your long-term strategy. If not, make the necessary tweaks - you can move money around within your IRA and 401(k) without any tax bill – in order to get back to your target allocation.