You’re sitting in your favourite restaurant, hungry and expectant. The waiter arrives and reads out a long list of mouth-watering specials. Yet the moment he walks away, you find you can recall only the last item on the list. Congratulations, you’ve been struck by recency bias.
In psychology, the recency effect refers to a human tendency, when asked to remember a long list of items, to have a sharper recall of the last items on the list. No doubt you’ve experienced this at a party. When introduced to ten people, you only recall the name of the last one or two.
Recency in finance
The recency effect occurs in finance, too, although the consequences can be more serious than forgetting whether the potatoes were roasted or mashed or who the man in the blue shirt was.
Quite simply, if you are making investment decisions based on what happened in markets in the last week or the last day, you risk chasing past winners or perceiving as the greatest risk something that has already occurred and been priced in.
We have seen that in dramatic terms in recent months with some, generally non-advised, investors turning defensive in March at the peak of the coronavirus crisis, only to see risk assets bouncing back in equally dramatic fashion in the second quarter of the year.
Our cave brain
There is an evolutionary reason for this effect. Just as we did when we were hunter gatherers more than ten thousand years ago, our brains are programmed to respond to what we perceive as the most immediate threats. Equally, we are likely to see as the best opportunities those that proved themselves in the immediate past.
During particularly traumatic bear markets or rampant bull markets, this effect can be magnified. Our short-term memories (the human equivalent of computer RAM) dominate our decision-making process, extrapolating recent returns into the future.
The consequences of this behaviour are that people buy stocks at or near the top of the cycle or sell them at or near the bottom. In bull markets, this equates to fear of missing out, while in bear markets the overwhelming imperative is loss aversion.
“This time is different”
Of course, the most common response to those who warn of the recency effect is to observe that this time it is different. The view here is that something fundamentally has changed in markets and a more tactical approach is required when everything is so unsettled.
The problem with that argument is that while every crisis is certainly different in one way or another, that doesn’t make it any wiser for investors to base their strategy on the world being about to end.
How to respond
So, if this is human nature, how do we resist the impulse to put the greatest weight in our investment decision-making on what happened most recently?
The answer is in asset allocation and rebalancing. By far the biggest influence on your investment success is how you distribute your money across defensive and growth assets. That allocation should be dictated by your risk appetite, your goals and your circumstances.
If you have decided at your most rational moments, that your desired allocation is 40% defensive assets (bonds, cash) and 60% growth assets (shares, property), then that’s what you should stick with. If shares fall by 30% and bonds retain their value, your allocation will now be 49%/51%. If you respond to the market fall by selling more shares and buying more defensive assets (bonds), you might end up with the mirror-image portfolio of 60% defensive assets, reducing the positive impact of the stock market recovery when it comes.
In other words, the recency effect can drive you away from your target portfolio by encouraging you to change your strategy based on a small sample size over a short period. This is like a pilot who responds to turbulence by completely changing course.
A better response is to rebalance. If stocks have fallen sharply during the intervening rebalancing period, the adviser at the next opportunity will sell some bonds and buy shares to bring your asset allocation back on track. Likewise, if shares have done very well, some will be sold in order to buy bonds.
The important point is that your investment decisions should be based on your risk appetite, goals and circumstances, not on what happened in markets in the past quarter.
Going back to our original metaphor, it’s like ringing ahead about the specials before you arrive at the restaurant, planning accordingly and enjoying your night out without the anxiety.
Barry O'Neill is a Director at Carbon and can be contacted at email@example.com
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