The concept of "recency bias" is a principle in behavioral finance that has been known to have harmful economic implications for investors. This phenomenon happens when investors allow recent happenings to sway their future decisions, like an abrupt dip in the stock markets. Although this psychological tendency is common, relying on it can lead to unnecessary losses. Qualified financial professionals often advise against it, highlighting the importance of buying low and selling high.Investors often fall prey to the recent past, placing too much emphasis on market events like a crash or a boom of a certain asset. This can lead to decisions which are counter to their best interests — such as selling off shares in a panic. Much like the likelihood of being attacked by a shark after watching "Jaws," the chances of making a profitable investment decision are slim if a person succumbs to recency bias.Omar Aguilar, CEO and chief investment officer at Schwab Asset Management put it this way: "Would you want to go for a long ocean swim after watching 'Jaws'? Probably not, even though the actual risk of being attacked by a shark is infinitesimally small." Investors should keep this in mind to make wiser decisions and not be swayed by fear or euphoria.
Investors can easily be influenced by the latest market events, like a sharp decline in stocks or a sudden surge of bitcoin or meme stocks like GameStop — and it could mean losses. This tendency to focus on recent occurrences is called "recency bias" and is comparable to the impulse most humans feel after watching the 1975 thrill "Jaws"; despite the slim likelihood of a shark attack, the fear of the water is likely to remain. This irrational thinking also affects the investment world as people make decisions based on the recent past which may not be in their best interests — such as selling stocks in a panic.Omar Aguilar, CEO and chief investment officer at Schwab Asset Management, famously stated: "Would you want to go for a long ocean swim after watching 'Jaws'? Probably not, even though the actual risk of being attacked by a shark is infinitesimally small." Investors should be mindful of this insight and not be swayed by fear or euphoria.
An example that can be found in real life is this: the financial services sector was one of the most successful parts of the S&P 500 Index in 2019, as it showed a 32% annual return. When investors reacted to this and bought numerous financial services stocks, they were possibly unhappy to see that the sector's returns sunk 2% in 2020 - a year with a positive 18% return in the S&P 500 Index, according to Aguilar. Other situations which financial specialists have presented include putting a lot more money on U.S. stocks after having a series of low returns with international stocks, and believing too much in a mutual fund's latest performance results as a guide for a purchase decision.
Charlie Fitzgerald III, an Orlando, Florida-based certified financial planner, expressed that short-term market movements based on recency bias can adversely affect long-term returns, ultimately making it harder for clients to meet their financial aspirations. According to Fitzgerald, this concept usually comes down to either the apprehension of loss or "fear of missing out" (FOMO). Taking action due to this impulse is similar to trying to time the investment markets, which is not beneficial and tends to result in buying at high prices and selling at low ones. Fitzgerald, a principal and founding member of Moisand Fitzgerald Tamayo, pointed out that it's necessary for people to be aware that recency bias is usual and inherent. "It's a survival instinct," he said.
He compared recency bias to a bee sting. "Getting stung once or twice is enough to make me stay away," Fitzgerald said. "This type of thinking can override our normal logical thought process." According to Fitzgerald, investors are especially prone to recency bias when they are close to making major changes in their lives, like retirement, and the fluctuations of the market seem particularly threatening.
Investors with a wide-ranging portfolio can be positive about enduring a crisis as opposed to selling in a rush. Most likely, this portfolio will feature substantial exposure to equities, including large, mid and small-cap stocks, international stocks and maybe real estate. It may also consist of short-term and intermediate-term bonds, along with a tiny bit of money in cash.
Investors can attain broad market coverage by purchasing various low-priced index mutual funds and exchange-traded funds that mirror these divisions. Another option is to buy an all-inclusive fund, for example a target-date fund or well-balanced fund. Normally, one's asset allotment - the fraction of stock and bond holdings - is governed by criteria such as investment horizon, resistance for risk and capability to take on risk, Fitzgerald said. To illustrate, a younger investor with 30 years before retiring may have at least 80%-90% in stocks.
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