How the Recent Past Impacts Your ReturnSubmitted by Castlebar Asset Management on June 2nd, 2016
As humans we are built to recognize patterns. If we roll two dice and they come up with snake eyes three times in a row our natural inclination is to think that on the fourth time they’ll come up again. The odds remain the same to roll two ones on the dice but our minds are drawn to the trend. Overtime these trends start to form biases in our thinking. This is called recency bias and when it comes to your investments it can have an impact on your performance.
The recent past weighs on our minds and can impact how we manage and allocate our investments. We tend to overweigh recent trends and discount longer term information which may contradict our current thinking. During periods of rising stock prices we expect markets to keep moving higher. While in times when stocks are selling off we expect stock prices to remain lower.
How does recency bias impact your financial life? The two areas are in investments and in spending. With your investments it can lead to behavior that will deviate from your ideal investment allocation. When markets are moving higher you keep buying or don’t want to sell your rising investments. This can lead to your investment allocation being out of alignment because you are overweight in the rising asset and underweight the other asset classes. Holding onto your winners can also lead to concentrated holdings. Both can lead to more risk than needed. Remember trees don’t grow to the sky and neither do stocks!
When markets are selling off your natural inclination is to put your cash in the mattress. It does not feel good to buy when things are lower in the markets. Trying to time the market based on how things performed over the last week, month or year could leave you missing out. One day markets will recover after a sell off and you’ll be on the sidelines with no plan to get back in.
Recency bias also impacts our spending. You are more inclined to buy a four-wheel drive SUV after a blizzard in January or buy a convertible on a gorgeous summer day. I have even seen clients buy cars on vacation because they did not have enough space on a road trip. These moves can throw our spending off course. Your recent experience has produced a feeling that you look to solve with a quick purchase. This doesn’t necessarily make sense in the long term and doesn’t mean we should change our spending.
Addressing recency bias is pretty straightforward. If you are basing your decision primarily on the recent past, ask yourself if there is other information that will support this decision. Having a plan to rebalance your investments on a regular basis, like once a year, can also help reduce the impact of recency bias on your investments. A personal financial advisor can help manage this for you. Personal financial advisors are not immune to recency bias but are more likely to look for other evidence and will rebalance according to plan despite what recent performance has been.
Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your personal financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.