MSG Team's other articles

12345 The Apple-Qualcomm Legal Battle

Apple Inc. is the largest and the most profitable company in the entire world. However, of late, it has also found itself in the middle of several lawsuits. The company has been facing a legal battle with Spotify of late. However, none of the legal battles even come close to the legal drama that is […]

11813 What are Eurobonds?

The Eurobond market is one of the largest debt markets in the world. It comprises a large portion of the debt which is issued by multinational companies as well as governments. It is therefore important for any student of fixed income securities to be aware of what Eurobonds are. The fact that these bonds are […]

12684 Centralized Cryptocurrency Exchanges

The popularity of cryptocurrency is causing investors to make a beeline for buying into the cryptocurrency boom. The trading activity in these markets has increased manifold in the past few years. However, novice investors can find it difficult to understand how cryptocurrency is bought and sold. This is particularly important since there is more than […]

9582 How Corporate Taxes Impact Corporate Behaviour?

Corporate taxes form a significant portion of the expenses borne by multinational corporations. These corporations are almost obsessed with efficiency. They continuously try to reduce their expenses so that their profitability can be increased. This is the reason why these companies are very sensitive even to minor changes in the tax regime. In this article, […]

9707 How to Invest In Commodities Markets

There is more than one entry route if one wants to gain an exposure in the commodities market. Positions can be built via many alternate routes. In this article we will look at some of these routes as well as their pros and cons. Physical Purchase Physically purchasing the commodities is the most direct and […]

Search with tags

  • No tags available.

There is a common saying in the investment markets that “In the short run, the markets are a voting machine whereas, in the long run, they are a weighing machine.” This saying is often said in order to emphasize the role of long term investment. People with short term goals often fail to perform well in the stock market. Despite all the emphasis on the long term, surprisingly, investors tend to focus a lot on the short term. Not only are their decisions related to forecasts of short-term future events, but these decisions are made on the basis of recent events, i.e., events that have taken place in the short-term past. This is called recency bias. In this article, we will have a look at what the recency bias is as well as how this bias impacts the performance of investors.

What is Recency Bias?

The gist of recency bias has already been mentioned above. However, the formal definition of recency bias states that it is a cognitive tendency of investors to place more emphasis on events that have taken place recently in the financial markets. To understand it better, we must think of the decision being made as a weighted average of our experiences in the past. We tend to give more weight to the event which has happened recently. If another event has happened five years earlier, it will be given less importance. Similarly, if another event has happened ten years earlier, then we tend to give it even less importance. This is in line with the way human memory works. Human beings tend to recall items at the beginning of a list of the ones which have been most recent.

How Recency Bias Affects Investment Decisions?

The biggest misuse of the recency bias is done by mutual funds and other fund managers. This is because these fund managers often use the track record of a couple of years when their funds have produced good returns in order to lure investors into making investments with them. They often don't provide any benchmarks for comparison. For instance, they might tell investors that the return for the past two years has been earned at 19% per annum. However, they will not tell how the fund performed prior to that.

The problem with the recency bias is that it deviates the investors from the cyclical nature of asset returns. In general, assets that have gone up in the past need not necessarily continue to go up in the future. On the other hand, it is quite likely that because of their cyclical nature, assets that have performed well in the past may have a greater likelihood of performing badly in the future since asset prices tend to move in cycles. Investors who have recency bias find assets with significant appreciation in the past to be unduly attractive. This makes them vulnerable to purchase stocks at the highest peaks.

Investors who suffer from recency bias tend to extrapolate current trends and predict the future based on very small sample sizes. For instance, they might only see the performance of the markets in the past two months or so and may extrapolate the trend to conclude how the market is poised to behave over the next decade.

Recency bias causes investors to place less importance on fundamental value and put undue emphasis on recent performance. For instance, in some cases, companies might need to take some short term losses in order to ensure long term gains. In such cases, if there is an undue emphasis on short-term returns from investors, which causes more harm to the company. The problem with the approach here is that it focuses only on the price-performance and not on the fundamental valuation. This is the reason that recency bias can cause principal losses to investors as well.

Recency bias often convinces the investors that the changes may be permanent this time. They tend to forget that over the long term, asset classes do revert to their means. Hence, until there has been a fundamental change in the industry, the situation may not be all that different as compared to the last time.

Recency bias causes investors to place all their eggs in one basket. Instead of having a diversified portfolio, they tend to have all their money in the same asset class, i.e., the one that has been appreciating the most in the past. Given the tendency of these investors to buy investments at the highest valuation, this can be a dangerous strategy. This irrational infatuation that investors may have with an asset class causes their portfolio to be damaged. This is because the behavior done by investors is the opposite of proper asset allocation, which is crucial for long term success.

How Can Recency Bias be Avoided?

The root cause of the recency bias is that the inference is drawn from the data sample, which is too narrow. Hence, in order to avoid recency bias, investors must make sure that they look at different types of data. For instance, they must look at the price-performance data as well as the fundamental valuation data. Also, they must look at various indicators over a longer period of time. The only way to avoid recency bias is to not be myopic.

It is important for investors to ensure that they are not afflicted with the recency bias. As we can see from the above article, the consequences can be quite grave.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

Cultural Influences on Financial Decisions

MSG Team

Contrarian Investing

MSG Team

Conservatism Bias

MSG Team