Recency bias. Risk analysis of the longer-term data makes sense, doesn’t it?

Recency bias is a cognitive bias where people remember recent events more easily and believe they will happen again soon. It affects investment decisions by focusing on short-term performance, leading to poor returns and higher risks. Discover whether you are prone to a recency bias and the extent to which it affects your investment decisions with PRAAMS BehaviouRisk.

Behavioural science. What is recency bias?

Recency bias is a widely present psychological pattern whereby people recall the most recent events more readily than those in the distant past. Moreover, they may incorrectly believe that recent events will reoccur soon. A good example would be investors focusing on the most recent (say, up to three years) performance results of a fund or manager without financial risk assessment of the longer-term (say, up to 10 years) performance. 

Recency bias is a cognitive bias, i.e., a mistake in decision-making. These biases can be effectively corrected with education.

What are the consequences and investment risks? 

The performance of asset classes is cyclical: in one period, equities perform better, and in the next, bonds may take the lead. Recency bias encourages cycle following, exposing one to poorer returns and more significant risks and less diversification than required by efficient asset allocation. This is because following the cycle means one makes an investment decision closer to its end. Even worse, deep reliance on a short performance history is highly detrimental to your investment objectives because it increases the chances of investing in a bubble that is about to burst. Also, relying only on the few most recent observations cannot provide a statistically objective picture. 

What can I do to make my portfolio more efficient?

First, it is wise to get rid of the “this time it’s different” asset allocation strategy. It is very harmful because it does not consider a more extended history, which is essential for any risk management framework. Recency bias may prompt you to adopt a return-chasing mindset, resulting in overly concentrated portfolios. No one knows where the markets will be tomorrow, and it makes little sense, especially for individual risk-aware investors, to place large bets on a few selected investments. Studies clearly show that better long-run results are produced by diversified portfolios that can withstand cycles. The second piece of advice is never to make any decisions based on small samples or partial information. The fundamental law of statistics states that only by using larger samples can one obtain a comprehensive risk-return relationship picture and form a solid basis for smart investment. Of course, looking for information is time-consuming and may cost you a little. Think of it not as a cost but as an investment in your better future returns. Good investment research always pays off!