Cognitive biases are an artifact of human evolution—quirks in our collective psyche which at one time or another helped us survive, but which in modern life often cause more harm than good. This is especially true when we let our cognitive biases override logic and influence our investment strategy.
One of the most powerful cognitive biases that can wreak havoc on your investment success is known as recency bias. Below, we define recency bias, explain how it can hurt investors, and explore tactics you can use to avoid its negative effects.
What is recency bias?
Recency bias is the human tendency to give more weight and consideration to the most recent news as opposed to past news, experience, or known trends.
This tendency can be helpful in certain situations, such as when our hunter-gatherer ancestors were searching for a source of food. After all, knowing where a herd of animals was last spotted or where a crop of forest berries was last seen is valuable information that could be used to find that next crucial meal.
But in other situations, such as investing, it can have serious negative repercussions and hinder long-term success.
How can recency bias hurt investors?
When investors place too much emphasis or importance on recent events, it can cause them to rethink, deviate from, or abandon their investment strategy. It also makes it more difficult to see longer-term trends that are, in most cases, more important than short-term market gyrations.
Recency bias in investing can take a number of different forms.
One of the more common forms is when an investor uses a company’s most recent performance data or share price action as justification to invest or not invest—while disregarding longer-term trends, the macroeconomic environment, and other data.
As an example, imagine that the price of a certain company’s stock rises by 30% in a single day. An investor might see this news and impulsively buy out of fear of missing out, without considering the longer-term trend in the stock’s share price. From that longer-term perspective, however, we see the stock has been on a downward spiral for months. And within six months of that initial purchase, the stock actually closes at an all-time low, despite having had that 30% one-day jump.
Another common form of recency bias is when investors look at the latest releases of certain economic data, such as unemployment rates, GDP, or inflation, and allow that news to materially affect their investment strategy—again, without taking into consideration the longer-term data that helps put the most recent news into perspective.
For example, imagine that during one of the Fed’s eight annual meetings, they announce that they will be raising interest rates. An investor who is heavily invested in bonds (perhaps a retiree) sees this news, panics, and sells his bond positions, because he knows that higher interest rates tend to be bad news for bondholders. In doing so, he locks in his losses and loses money.
As you can see, one good quarter doesn’t necessarily mean a struggling company has turned itself around, and speculation about whether the Fed is going to raise interest rates doesn’t automatically mean it’s a disastrous time to own bonds. Without additional context, it’s impossible to draw an accurate conclusion, which is what makes recency bias such a dangerous thing for investors.
Buying because of a fear of missing out and selling in a panic are understandable human impulses, but they are not reliable ways to grow your investments over the long term.
How to Avoid Recency Bias
Investing requires discipline, which is a learned skill that must be practiced. With this in mind, one of the best ways to minimize the threat of recency bias is to approach investing as a long-term endeavor.
This makes it much less likely that you’ll panic-sell during a downturn, and also less likely that you’ll panic-buy during a bubble. In fact, embracing a long-term investment mindset might even help you reconceptualize market downturns not as a loss, but as an opportunity to buy (and similarly, to view rapid, bubble-like rises as an opportunity to rebalance your portfolio into undervalued assets).
Further, easing into your position over time instead of all at once—a tactic known as dollar-cost averaging—can also help.
Dollar-cost averaging involves investing a consistent amount of money on a regular schedule, for example, every week or every month. This allows you to ride out the fluctuations in an asset’s price, buying more shares when the price is lower, and fewer shares when the price is higher. As a result, DCA can lead to less volatility compared to just going all-in on an investment from the beginning.
Here at Allio, we believe that saving and investing money consistently over time is one of the most powerful tactics that you can use to build wealth. That’s why we’ve built our app with dollar-cost averaging in mind. By turning on our round-ups feature, you’ll passively invest money every time you spend. Likewise, you can make recurring investments on a regular schedule so you know you’re always working toward your financial goals.