Recency Bias – could it derail your plans?
Stock market returns were phenomenal in 2024. But strong returns can plant the seed for an unexpected risk. This risk is known as recency bias. Holding an awareness of recency bias is the best way of ensuring you don’t fall victim to its draw, so this week, let’s take a look at this often overlooked risk factor.
What is Recency Bias?
Recency bias is a cognitive bias that causes people to place too much importance on recent events, often at the expense of longer-term trends or historical data. This tendency can lead to overreactions or misguided decisions because the human brain naturally prioritizes what is fresh in our memory.
For example, if you’ve recently experienced a period of strong returns in the stock market, you might start to believe that these gains will continue indefinitely. Conversely, if the market has been through a rough patch, you may feel overly pessimistic and make rash decisions like pulling out of investments at the wrong time.
How Does Recency Bias Show Up in Financial Decisions?
Recency bias can sneak into your financial life in several ways. Here are some of the most common scenarios:
1. Overreacting to Market Corrections
When markets experience a sharp decline, as they inevitably do from time to time, recency bias can trick you into thinking that the downturn will last forever. This leads many investors to sell out of fear, locking in losses and missing the eventual recovery. For Australians who lived through events like the 2008 Global Financial Crisis or the COVID-19 market crash, these reactions may feel justified, but history consistently shows that markets recover over time.
2. Chasing Hot Investments
On the flip side, when a particular asset class or investment performs exceptionally well, people tend to jump on the bandwagon. Think of the tech stock boom in the late 1990s or the cryptocurrency frenzy more recently. Investing based solely on recent performance often results in buying high and, unfortunately, selling low when the bubble bursts.
3. Changing Spending Habits
Recency bias isn’t limited to investing. If you’ve recently received a pay rise, you might start spending more freely, assuming that higher income is here to stay. We sometimes call this lifestyle inflation. It can become a trap where you end up in a role you dislike, but fear exiting because your inflated living costs demand the high salary that the role provides.
4. Underestimating Risks
During periods of economic stability, people may downplay the importance of emergency funds or adequate insurance coverage. Recency bias can lead to a false sense of security that may be shattered by unforeseen events, such as a job loss or a health crisis.
Strategies to Guard Against Recency Bias
Recognising recency bias is the first step to overcoming it. Here are some practical strategies to help you stay on course:
1. Focus on Your Long-Term Plan
A well-thought-out financial plan is your best defense against knee-jerk reactions. Set clear goals for your investments and stick to them, regardless of short-term market fluctuations. For example, if your aim is to retire at 60 with a certain level of income, keep that objective front and center when making decisions.
2. Diversify and Rebalance Your Portfolio
Diversification reduces risk. By spreading your investments across different asset classes and geographic regions, you’re less exposed to investment cycles. But over time your allocations can get out of whack. In 2024 it may be that your US share exposure is now higher than you had originally intended. Consider rebalancing back to your target allocation as a way to control risk.
3. Revisit Historical Data
When tempted to make a decision based on recent events, take a step back and look at the bigger picture. Long term returns from stock market investments is likely to be around 8%. Use this as your reference point, not whatever was the return in the past year.
4. Automate Your Investments
Setting up automated contributions to your superannuation or investment accounts can help remove emotion from the equation. Dollar-cost averaging, where you invest a fixed amount at regular intervals, ensures that you’re buying both when markets are up and down, averaging out your costs over time.
5. Discuss things with your Financial Adviser before acting
One of our roles as your advisor is to act as a sounding board and help you avoid impulsive decisions. Make use of the resource that you have available.
The Cost of Ignoring Recency Bias
Failing to address recency bias can lead to costly mistakes, for example:
Being over – exposed to particular assets and seeing declines in your total wealth that is disproportionate to what should have occurred had you remained appropriately diversified.
Missed Opportunities – Selling investments during a downturn or avoiding markets out of fear means missing out on potential gains.
Increased Stress – Constantly reacting to short-term events can create unnecessary stress and anxiety.
Recency bias is a natural human tendency, but it doesn’t have to control your financial decisions. By understanding this bias and implementing strategies to counteract it, you can safeguard your plans and stay focused on what truly matters: achieving your long-term goals.
If you need help with your retirement planning, that’s exactly what we do at Guidance Financial Services. Learn more below.
