How Recency Bias Affects Investment Decisions?

Explain : 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.