How To Avoid Recency Bias Trading & Investing In Stocks | Cognitive Biases

How To Avoid Recency Bias In Trading & Investing | Cognitive Biases

Recency bias is believing what occurred in the recent past will continue to occur in the future.

Say you flip a coin and get heads five times in a row. Naturally you’ll begin to think the sixth flip will also be heads. Heads is the trend.

But in reality, you’d be wrong. This is called recency bias. You’re letting recent outcomes incorrectly influence your belief of future outcomes.

No matter the outcome of the previous trials, the probability of the next coin flip being heads will always be 50%. Believing anything else is illogical.

Investors consistently fall victim to this bias. It’s the main contributor to the complacency we see during each market cycle.

Consider the “buy the dip” mentality that plagued the post-QE era. One of the greatest financial crises in history occurred 8 years prior, and in the time in between investors trained themselves to throw risk management out the window and aggressively buy more each time the market fell.

It’s true that “buy the dip” worked well during that time, but there was no guarantee it would work in perpetuity. This is especially true considering the nature of market cycles. Strategies tend to work for a period of time until they don’t. And it’s usually the previously successful strategies that end up failing the hardest in the new environment. No one wants to be caught buying the dip when the market morphs from bull to bear. But unfortunately, recency bias leads a majority of investors straight off that cliff.

“Buy the dip worked before… so it must work again!”

Nope. Sorry.

As always, stay Fallible out there investors!

***All content, opinions, and commentary by Fallible is intended for general information and educational purposes only, NOT INVESTMENT ADVICE.

[davidgregg]

Think Twice by Mauboussin- best book on cognitive bias'. Short, sweet, and stacked with reference and source material.

[ZBiBU]

I am actually conducting my research on behavioural finance and emotional and cognitive biases. A survey which I am conducting can be found here. Would be really helpful if you could give me some feedback on this issue.

[devonhayes]

Another great video man. Evolutionary biology has set us investors up to fail. I do have to disagree with you on the dip buying point of view though. The whole name if the game is to buy low and sell high. One if my favorite trading strategies is to buy when a stock dips below my intrinsic value and sell it as it rises up. Strategically buying the dips every 5% below intrinsic value and selling a chunk every 5% above it. The main thing is the underlying stock. As long as it is fundamentally strong it will always bounce back. Of course momentum trading is totally different. Still though keep it up

[USA_SNEAKLEAKER]

And then people try to rationalize a failing strategy....

[joergmueller]

Also his other book The success equation - highly recommended.

[DynastyJr]

So are you like from India or your parents are?

[stevenwang]

Hmmmm “are they about to go cut vegetables?”