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Behavioural Biases And Their Effects On Investment Decisions Series- Part 4

Investment is not a number; in fact, it is a mind game. The entire phenomenon and process of investment is guided and controlled by the mind of the investor and the fellow-investors. This is the reason why the financial market, and investments, in particular, get affected by the behavioural biases.

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The most important characteristic of investment is making a decision. This means that decisions need to be made after keeping in mind what, where, when and how much to invest. These decisions are majorly affected by what the investor thinks and his emotional response. Thus, investment decisions get easily swayed by behavioural biases.

Recency Bias

The recency bias involves focusing on recent or upcoming events rather than the long-run thesis. The investors with recency bias tend to use only the latest information and ignore the history. They focus on the most recent information and disregard the older but equally important pieces of information. However, this is not how investment instruments function. There is no form of investment that follows a pattern and guarantees that a trend will be repeated.

It is one of the strongest trading biases. Researches have shown that about 39% of the new money committed to mutual funds goes into the top 10% mutual funds that performed the best in the previous year. The investors with the recency bias only look at the most recent data regarding performance and follow it.

The disclaimer is always mentioned with mutual funds and investment instruments that past performance is not indicative of the future performance. Yet, the investors with recency bias are inclined towards predicting the future based on the past. This makes them take decisions with insufficient information and not-so-good results.

Causes of the Recency Bias

Humans have a short memory, which becomes shorter when it comes to investment cycles. The investors tend to remember the things that happened more recently to a larger extent and seem to forget the past. For instance, a company’s stock was performing quite badly in the past, with low earnings, revenues, dividends etc. and then suddenly the company declared a huge dividend for its shareholders in the month of December. Due to the recency bias, the investors will have the tendency to remember that the company pays high dividends and buy the stock, rather than looking at the past long-term non-performance. During the bull market, people tend to forget about the bear market. This happens the other way round, too.

Recency bias is also caused by the fact that humans are very talented at finding patterns, and when they detect the patterns, they believe in their validity. Investors also believe that what happened recently will continue to happen in the future, whereas the truth is that the asset classes swing from being fairly-valued to overvalued to undervalued, or anywhere in between.

Effects of the Recency Bias

Recency bias makes the investors take decisions biased by the most recent performances, instead of looking at the big picture. It can cause the markets to go up and down in an exaggerated way. It was, in fact, the recency bias that had worsened the stock market downfall in 2008-2009.

When the market is going down, the investors affected by recency bias assume that the markets will never go up. They forget the past performances and that the market was up just a few days ago. As a result, the investors stop taking risks and their sense of recency overrides their rationality.

The recency bias not only harms the overall markets but also the individual investors to a large extent. The investors who keep sitting with their heads in the sand, thinking that the market has gone down and won’t come back up, do not realise when the market takes a natural turn and bounces back up. Due to the recency bias and the prejudice, they end up losing some excellent investment opportunities. Thus, the recency bias is detrimental to the entire financial system.

How to Overcome the Recency Bias?

The most important way to overcome recency bias is by deliberately teaching oneself that the most recent information needs not be the most accurate information.

This can be done by keeping a trade journal to keep reminding oneself of the changes that happened in the past. This will help the investor to remember that the particular stock has had an upside/downside in the past and the present information is not the complete picture. It will help the investors gain the right perspective and take a decision based on facts and not be influenced only by the recent developments.

Many investors also use the ‘periodic table of investment returns’ to keep in mind that the assets are cyclical in nature. The best-performing assets in one year may be at the bottom of the chart in the subsequent years. The periodic table helps the investors keep a track of these changes and helps them take correct and fact-based decisions, rather than extrapolating the recent events into the future.

As a bottom line, it is critical for the investors to stay clear of the recency bias to ensure that they are able to look at the big picture and not take decisions based on the most recent colour.