Investors can get swept away by the fear or euphoria of the recent past, and it often costs them financially.
Recency bias is the tendency to put too much emphasis on recent events, such as a stock-market rout, the meteoric rise of bitcoin or a meme stock such as GameStop, for example.
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Investor choices are guided by these short-term events, which may be counter to their best interests, as is often the case when selling stocks in a panic.
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Recency bias is akin to a common yet illogical human impulse, such as watching Steven Spielberg’s classic summer blockbuster “Jaws,” a 1975 thriller about a Great White shark whose diet revolves more around humans than marine life, and then being afraid of the water.
“Would you want to go for a long ocean swim after watching ‘Jaws’? Probably not, even though the actual risk of being attacked by a shark is infinitesimally small,” wrote Omar Aguilar, CEO and chief investment officer at Schwab Asset Management.
Recency bias is normal, but can be costly
Here’s a recent real-world illustration.
The financial services sector was among the top performers of the S&P 500 Index in 2019, when it yielded a 32% annual return. Investors who chased that performance and subsequently bought a bunch of financial services stocks “may have been disappointed” when the sector’s returns fell 2% in 2020, a year when the S&P 500 had a positive 18% return, Aguilar said.
Among other examples posed by financial experts: tilting a portfolio more heavily toward U.S. stocks after a string of underwhelming performance in international stocks, and overreliance on a mutual fund’s recent performance history to guide a buying decision.
People need to understand that recency bias is normal, and it’s hard-wired.Charlie Fitzgerald IIIfounding member of Moisand Fitzgerald Tamayo
“Short-term market moves caused by recency bias can sap long-term results, making it more difficult for clients to reach their financial goals,” Aguilar said.
The concept generally boils down to fear of loss or a “fear of missing out” — or FOMO — based on market behavior, said Charlie Fitzgerald III, an Orlando, Florida-based certified financial planner.
Acting on that impulse is akin to timing the investment markets, which is never a good idea. It often leads to buying high and selling low, he said.
“People need to understand that recency bias is normal, and it’s hard-wired,” said Fitzgerald, a principal and founding member of Moisand Fitzgerald Tamayo. “It’s a survival instinct.”
It’s like a bee sting, he said.
“If I get stung by a bee once or twice, I’m not going to go there again,” Fitzgerald said. “The recent experience can override all logic.”
Investors are most vulnerable to recency bias, he said, when on the precipice of a major life change such as retirement, when market gyrations may seem especially scary.
How to assemble a well-diversified portfolio
Long-term investors with a well-diversified portfolio can feel confident about riding out a storm instead of panic selling, however.
Such a portfolio generally has broad exposure to the equity markets, via large-, mid- and small-cap stocks, as well as foreign stocks and maybe real estate, Fitzgerald said. It also holds short- and intermediate-term bonds, and maybe a sliver of cash, he added.
Investors can get this broad market exposure by buying various low-cost index mutual funds or exchange-traded funds that track these segments. Or, investors can buy an all-in-one fund, such as a target-date fund or balanced fund.
One’s asset allocation — the share of stock and bond holdings — is generally guided by principles such as investment horizon, tolerance for risk and ability to take risk, Fitzgerald said. For example, a young investor with three decades to retirement would likely hold at least 80% to 90% in stocks.