Imagine you are at a house party playing cards with friends. Your friends are betting on the probability of drawing a card that is either – a ♣ Club, or a ♠ Spade. So far you observed that the outcome is: ♠, ♣, ♣, ♣, ♣. On the next draw, you are tempted to place a bet.
If you are thinking that the next card will definitely be a ♣ since the last four have been so, then you are likely falling into the trap of Recency Bias. Recency bias is the tendency to place too much emphasis on experiences that are freshest in your memory even if they’re not the most relevant or reliable.
Some of you may also have thought of picking ♠ this time as ♣ have already occurred four times in a row. Then you, my friend are under the influence of another bias called Gambler’s Fallacy. We will talk about this cognitive bias in another article.
We tend to avoid talking to people we recently argued with or not eat at restaurants where we recently had a bad experience. Unfortunately, because of recency bias, basing predictions on recent positive experiences can be dangerous. In stock markets, almost everyone looks for stocks that have performed well in the recent past. Blinded by the gains pocketed by the family, friends, or a few stock market gurus, several new stock investors could get aggressive. And in doing so, could forget that the bull or bear market cannot last forever. Last year taught us a powerful lesson, in both directions. Optimism was the order of the day in mid-2020 with the market making all-time highs. Compare that with March 2020, when things looked like they would never recover. In both cases, investors would have been well-served not to assume the recent past was going to continue forever. This also the reason many investors suffered heavily during the market crash of 2008 and failed to gain from its subsequent rally in 2009. Same goes for any asset class, be it gold, silver, small-cap stocks or bitcoins frenzy.
As an investor, has it ever happened to you that you made a good average annual return in the last 5 years. However, in the last twelve months, your portfolio is not giving good returns. Here, because of recency bias, you might feel negative and may believe that the market is not working in your favor anymore. However, this is not the complete reality. What you need to do is get a grasp on the long-term source. Having a myopic view means that you are constricting yourself to the narrow and short-term view. Short-term market moves caused by recency bias can sap long-term results, making it more difficult for investors to reach their financial goals.
Recency bias explicitly violates one of the most fundamental tenets of successful investing: the buy low, sell high maxim. Investors tend to chase returns, buying yesterday’s winners. Remember that you're in it for the long haul. Focus on the long-term performance of your investments, limit how much attention you pay to fear-mongering or excitement-filled media reports. The key is to strike a balance between fear and greed, and to make well-thought and planned investing decisions. As Benjamin Graham has said, “In the short term the market is a popularity contest; in the long term it is a weighing machine”.
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