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Investors can be carried away by the latest fear or euphoria, which often results in financial losses.
Recency bias refers to the tendency to overemphasize recent events, such as a stock market crash, the meteoric rise of Bitcoin, or meme stocks like GameStop.
Investors’ choices are guided by these short-term events, which can be against their best interests, as often happens when stocks are panic-sold.
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Recency bias resembles a common but illogical human compulsion, 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 fears water.
“After watching Jaws, do you want to take a dip in the ocean? Probably not, although the actual risk of being attacked by a shark is minimal.” wrote Omar Aguilar, CEO and Chief Investment Officer, Schwab Asset Management.
Fans celebrate the June 14, 2005 release of Universal Studios Home Entertainment’s 30th Anniversary DVD of Jaws.
Christopher Polk | Movie Magic | Getty Images
Recency bias is normal, but can be costly
Here’s a recent real world illustration.
Financial services is one of the best performing sectors S&P 500 Index In 2019, its annual return was 32%. When the S&P 500 returned 18% positively in 2020, the sector returned 2% in 2020, and investors who chased that performance and then bought a lot of financial services stocks “could be disappointed,” Aguilar said.
Other examples cited by financial experts include a portfolio shifting more toward U.S. stocks after a string of underperformance in international stocks and an overreliance on mutual funds’ recent performance history to guide buying decisions.
People need to understand that recency bias is normal and inherent.
charlie fitzgerald iii
founding member of mothan fitzgerald tamayo
“Short-term market volatility caused by near-term deviations can undermine long-term performance and make it more difficult for clients to achieve their financial goals,” Aguilar said.
Charlie Fitzgerald III, a certified financial planner in Orlando, Fla., says the concept often boils down to a fear of loss, or “fear of missing out” (aka FOMO), based on market behavior.
Acting on this impulse is akin to timing the market, which is never a good idea. That often results in buying high and selling low, he said.
“People need to understand that recency bias is normal and inherent,” said Fitzgerald, principal and founding member of the Moisand Fitzgerald Tamayo. “It’s a survival instinct.”
It was like a bee sting, he said.
“If I got stung by a bee or two, I wouldn’t go there again,” Fitzgerald said. “Recent experience defies all logic.”
Market volatility can appear especially frightening when investors face major life changes such as retirement, and they are most susceptible to recency bias, he said.
How to Build a Diversified Investment Portfolio
However, long-term investors with a diversified portfolio can ride out the storm with confidence rather than panic selling.
Such a portfolio typically has broad exposure to the stock market through large, mid and small-cap stocks, as well as foreign stocks and even real estate, Fitzgerald said. It also holds short- and medium-term bonds and perhaps a small amount of cash, he added.
Investors can gain broad market exposure by buying a variety of low-cost index mutual funds or exchange-traded funds that track these market segments. Alternatively, investors can buy all-in-one funds, such as target date funds or balanced funds.
A person’s asset allocation — the share of stock and bond holdings — is usually guided by principles such as investment horizon, risk tolerance and risk-taking ability, Fitzgerald said. For example, a younger investor who is thirty years away from retirement is likely to own at least 80% to 90% of the stock.
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