How investors can avoid the dangers of recency bias
We may not be as rational as we think in our assessments and reactions to the market, and vivid memories of the recent past may subconsciously distort our judgement. But there is a way to cut through, writes Nick Armet.
Recency bias is the name for the heavy influence that recent experience can have on our decision making. It is a particular problem for investors in financial markets where momentum effects can be strong and persuasive.
Yet, an awareness of its drawbacks is essential if we wish to navigate market turning points or simply put current asset prices into a longer-term context.
Recency exerts its influence continuously, subtly, and mostly at an unconscious level, yet there are some practical steps investors can take to avoid its negative consequences.
In tests of memory recall, it is well-proven that people remember best the last thing you told them.
The concept of finite working memory helps to explain why people remember the last item in a list, but the same analogy holds for a longer-term recency effect which biases our thinking, known as ‘contextual drift’.
This means that the context we apply to our thinking at any given moment can be thought of as a recency-weighted sum of previous experiences or memories.
The evidence suggests that investors tend to heavily overweight personal experience at the expense of statistics. Personal experience trumps general experience.
The reason for this is the impact of emotion. When you have ‘skin in the game’, positive and negative market events that affect your portfolio are much more keenly felt and trigger memorable emotional responses.
And, when recency combines with vividness, (something behavioural psychologists call salience), the effect is even more powerful. The combination of the two helps to explain the high current price of safety in financial markets.
The financial and sovereign crisis remains fresh in investors’ minds, despite the stock market rally of the last few months.
Only last year, it seemed quite clear to many that Greece would leave the euro and spark a broader Eurozone crisis.
Going back in time, the recency effect begins to fade, but the distinct fear that greeted the Lehman collapse in October 2008 remains recent and vivid enough in the minds of many investors. This was the most serious crisis in a generation.
Such crises are actually very rare - we have to go back to the 1930s depression to find a genuine precedent.
Prior to the financial crisis, investors had largely underestimated the likelihood of such an event precisely because the last one had been so far in the past (and one they had no personal experience of).
Now, the opposite appears to be the case; the fact that such a significant crisis happened in recent memory has made investors overestimate the odds of a recurrence.
High demand for safe assets has helped to drive the price of government bonds like US Treasuries and German Bunds down to historic lows.
The recent rally in stock markets owes much to the perception that the worst of the sovereign crisis is over. Yet many investors continue to be heavily overweight in the safest assets at a time when the absolute risk/reward profile of those assets has become less attractive.
For example, a recent survey of retail investors by State Street found that they were mostly invested in cash.
They had 31 per cent of total assets in cash and expected to be 30 per cent invested in cash in 10 years time. This was in spite of widespread recognition that they needed to be more aggressive.
We can put much of this preference for safety down to recency bias. Sometimes, a bias to recency has no ill effect. Momentum is a well-observed factor that periodically helps to drive markets – ‘the trend is your friend’.
The trouble is momentum does not work all the time; occasionally markets overreact, assets become over- or -undervalued, before at some point reverting back towards their historical averages.
We should accept that our decision making can become fogged during these transitional phases. Certainly, recency bias helps to explain why it can take a while for many investors to react to genuine turning points in the market.
So what can investors do to avoid the trap of recent events dominating their thinking?
One solution lies in the application of systematic rules. Investment professionals have long recognised that a consistent, research-driven investment process is a valuable defence against psychological biases.
In the case of recency, deliberate consideration of a longer time horizon or data set helps to put the present environment into context.
For example, historic average valuations can guide our view on the present value of financial assets.
Put the present into a wider context
Graph 1 shows how far yields in financial assets are from their 10-year averages. Equities come out cheapest – the yields on non-financial equities are above average and the most attractive versus their own history.
That attraction becomes more persuasive when you look elsewhere – cash and bonds are yielding significantly below their respective 10-year averages.
Indeed, the expensiveness of government bonds is quite extreme. In statistical terms, current yields are said to be over 2 standard deviations below their 10 year average.
Another way of saying this is that over 95 per cent of government bond yield values over the last decade fell within a range that was higher than the current yield on government bonds.
Longer-term investors who believe in mean reversion may want to review the equity, bond and cash weights in their portfolios.
Another defence against recency bias is careful exposure to financial media. The impact of recency can be exaggerated by media coverage and our bias to another psychological effect called narrative fallacy.
This means we are highly susceptible to stories – so much so, that we look for patterns and explanations where there may only be randomness.
Every twist and turn in the market is attributed to something or someone. This provides an ever-present source of fuel for the ‘contextual drift’ that all investors must guard against.
Unhelpfully, it also encourages investors to look for ‘trigger events’ but miss the cumulative importance of incremental good news.
So, what can you do to beat recency bias? Try to take a long-term view wherever possible; filter media stories carefully; and be very wary of the blinkers of recent experience.
Instead, find joy in dull statistics such as average valuations, and, generally take a more systematic approach (or invest with a professional who does), and you could really improve your chances of beating the herd.
Nick Armet is the investment director at Fidelity Worldwide Investment.
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