In the corporate world, it is common to see managers giving importance to the employee’s work done in the last 3-4 months rather than considering the overall performance over the entire year. If the manager rewarded the employee with a wonderful bonus and salary hike, even though he did not perform well in the earlier months, we could say that the manager had recency bias.
Giving importance to recent events and overlooking events that happened a while back is a type of cognitive bias called Recency Bias. We can see this bias in different aspects of our day-to-day lives, including investments.
Recency Bias in Investing
Recency Bias is a very common cognitive bias in investing, and it can have disastrous consequences on the investment journey. It alters our views of the present, what’s important and of the future. It is because the short-term events may not repeat, and it may not have any significant impact in the long term.
Equity markets progress through market cycles and are marked with bull market, i.e. highs, and bear market, i.e., lows. However, during a bear market, investors forget about the bull market. During the market downturn, as stock prices plummet, market participants resort to panic selling because they feel that the market will continue to fall and it would never recover.
Because of this bias, the loss on paper becomes a permanent loss for the investors.
Let us take an example of an investor who started investing five years ago. He invested Rs.1 lakh in an equity mutual fund. Over the last five years, the investments increased to Rs.1.75 lakhs. However, the market fell sharply, and the investor’s portfolio was down Rs. 25,000 and stood at Rs. 1.50 lakhs. At that moment, the investor focuses on the loss of Rs. 25,000 and ignores the overall gain of Rs. 50,000 on the investment.
Looking at the recent events, the investor might sell the holdings or stop investing. Ideally, the investor should invest more to pick up stocks at attractive prices during a market fall.
How to avoid Recency Bias?
The first and most essential step in correcting any behavioural bias is an acknowledgement of the bias. Being aware of the bias will help you have an open mind and analyse investment decisions rationally.
Be aware of the working of the market: Equity markets move in a cycle. It is an intrinsic nature of the markets to go through periods of ups and downs. If you take an investment decision based on recent happenings, try to look at the larger picture.
Link your investments to your financial goals: Linking your investments with your financial goals makes it easier to stay away from recency bias. Have a financial plan and invest to meet your financial goals. Investing for your goals will make you a disciplined investor and help you take financial decisions rationally.
Take care of asset allocation: Instead of focussing on the short-term performance, give importance to asset allocation. The asset allocation mix of different assets will depend on your risk tolerance and financial goals. If your portfolio’s asset allocation becomes skewed to one asset class because of recent market developments, rebalance your portfolio to maintain the optimum asset allocation.
Take help from an expert: A second set of eyes always brings a fresh perspective to the table. During any knee-jerk movement in the market, investors are prone to take emotional decisions. In such a scenario, taking help from an expert will help you filter out emotions and focus on the right investment decisions.
We built our financial future on the financial decisions that we take. And as humans, we are prone to biases such as Recency Bias, where we prioritise recent events over long-term scenarios. Acknowledge it and fight against the bias to achieve your financial goals.