Recency Bias

Recency bias is a type of cognitive bias where people make conclusions based on recent events. They frequently lead people to make emotional decisions based on recent or short-term outcomes, neglecting the rational aspects of the situation and what happened in the past. This bias can affect investors hugely.

Recency bias may lead to people making short-term financial decisions incompatible with their long-term financial goals. Due to recent failures, businesses may refrain from investing in a certain firm or industry. Investors reject or welcome equities depending on what happened recently. Recency bias can also influence the quality of decisions.

• Recency bias is a psychological bias where people tend to make decisions based on the outcome of recent bias rather than looking at the larger picture.
• Recency bias is often prevalent in the financial and investment sectors.
• Even though it is impossible to eradicate this bias, one can take several courses of action to stay away from bad decisions influenced by recency bias.
• Understanding the financial market, having a clear goal set in mind, building a strong portfolio, hiring advisors, and keeping a positive attitude can help one bypass recency bias to some extent.

Recency bias in behavioral finance is a well-studied concept. Understanding it is essential because people frequently make rash investing or financial planning decisions due to recent events and the latest information. It often drives people to make emotional decisions that ignore the rational components of the circumstance and what has previously occurred. It's easy for individuals to believe that recent events will determine how the future unfolds. This behavioral bias stems from how humans rely on short-term memory to make sense of the world in real-time.

For example, an employee in a workplace can be evaluated for their recent shortcomings in performance or certain recent events even though they have been consistently showing good results for a long time in the past. In short, the concept establishes that emotions, for better or worse, are the primary triggers in major life decisions and that human memory and intuition are susceptible to errors.

Recency bias psychology prevails in financial markets more than often. Investors tend to fall for the fallacies of negative news and jump to conclusions regarding their investments. Conversely, when the news reports something positive, the investors jump in to invest, and when things do not work out for the company, the high price bubbles burst, and the invested money is lost. Similarly, markets have occasional market correction cycles; a person who is new to the process may not completely comprehend it. As a result, the investor may refrain from making further investments expecting the situation to continue thinking it is a bear market.

The following recency bias examples are provided to give readers a basic understanding of the concept.

Example 1# Recency Bias in Investing

Chris is a new investor who does not have much experience in the stock market and wants to invest in mutual funds. There were three famous companies, A, B and C, from which he had to choose. He looked into the data for the past decade, and their returns were 20%, 30%, and 50%, respectively. The obvious choice would have been "C" for any investor as it gives high returns that too for over a decade. Unfortunately for Chris, there was news that one of the investors of company C had invested in a tax default company.

Even though there were no direct connections between that company and company C, there had been a negative image created. The unintentional negative image influenced Chris. He believed that the government would drag company C into the allegations, their prices would drop, and he would lose all his savings. Therefore he chose the second-best option, "B," which did not have the best returns or consistent performance.

There was news with no direct connection, yet investors tend to develop negative emotions toward that company irrespective of the proven past track records. Similar examples in the financial markets demonstrate recency bias in investing and the importance of rational thinking among investors.

Example 2# Recency Bias in Behavioral Finance

Behavioral economics focuses on the emotions of people influencing their financial decisions. The Dotcom bubble of the 1990-early2000s is an example of how people go behind emotions and invest in speculations. There was widespread hype about the newfound internet industry. During that period, the sector witnessed an exponential growth of over 400%. The prices exorbitantly increased as more and more people invested. It was a cycle. People saw the price rise, and people invested for the price to rise. Eventually, a bubble was created, and soon enough, it burst, and the stock price fell around 70 %s. People fell into the herd mentality because it was popular and invested because of the recent price rise it portrayed.

It is nearly impossible to avoid recency bias completely because it is hardwired in humans to act on feelings generated by closer and clearer events. However, we can save ourselves from making bad decisions due to recency bias, especially in finance, by taking some simple measures. Some of them are:

1. Understanding the markets:

Stock markets work in cycles. There are periods of ups and downs. When the prices are high and booming, it is called the bull market, and when the prices go down is referred to as the bear market. The prices on reaching new highs can come down after investors try to make short-term profits by selling their existing holdings; they are called market corrections. It's important to understand their meaning and observe their timings over certain periods. The star-performing assets will continue to give good returns in the long run, irrespective of the number of bears encountered.

2. Clear financial goals:

Investors need to chart out their financial goals. Then, they shall make investments accordingly after thorough research. The plans shall be divided into short, medium, and long-term goals. Long-term goals especially need disciplined investments, and therefore, investing money should continue irrespective of the trends or recent events. Clear planning provides focus to investors.

3. Building a strong portfolio:

Investments are risky affairs. As much as they give profits, they also involve great risks. When investors invest in high-risk assets such as crypto, they should balance the risk by investing in low-risk debt funds. This guarantees them some amount of guaranteed returns if all goes downhill. Even when one or two investments perform poorly, other investments guarantee returns. This improves confidence and prevents panic in buying or selling thus eliminating recency bias to an extent.

4. Hiring financial advisors:

 It is human psychology to fall into patterns. Seasoned investors also go through such situations and stand apart because they do not act on them. This is where hiring a consultant or an advisor becomes essential. They have both experience and knowledge of the functioning of the markets. They can come in handy, especially in volatile markets.

5. Positive attitude:

As an investor, it is important to have a positive outlook on the investments made. They were made after thorough research and analysis. When the market is panic selling, it is essential to stop and think instead of giving in to the crowd. Analyzing the situation rationally and utilizing low prices to acquire more of that particular asset can be wise.

This has been a guide to Recency Bias and its definition. Here we discuss how Recency Bias works along with the examples and how to avoid this bias. You can learn more behavioral finance from the following articles- 

• Hindsight Bias
• Survivorship Bias
• Confirmation Bias