Five Ways To Combat Recency Bias In Your Portfolio

0
6
Combat Recency Bias
Free-Photos / Pixabay

What were you doing in mid-March? If you were like a lot of Americans, you might have been calling your broker or your financial adviser and demanding to get out of the market. On March 13, investors left in droves, taking with them a record $20.2 billion — the largest daily outflow ever recorded.

Get The Full Seth Klarman Series in PDF

Get the entire 10-part series on Seth Klarman in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

Q1 2020 hedge fund letters, conferences and more

On what did investors base their decisions? Let’s take a look at some of the news making headlines around that date. Just two days earlier, the World Health Organization declared the coronavirus outbreak a pandemic. On March 9, oil prices suffered their biggest collapse since 1991 after Saudi Arabia and Russia failed to agree on how best to manage the price of oil. During prior weeks, news headlines detailed the spread of the coronavirus to Europe, where in late February, Italy began to see a major surge in cases toward the end of the month. On February 29, the U.S. announced its first death.

Recency Bias: The Most Commonly Observed Bias

It’s understandable that such a string of bad news could lead investors to pull out of the market, but it’s also an example of how behavioral bias can drive us to make emotional decisions that may not be in our own best interests. When people make decisions based on information or events that have affected them recently, they’re likely suffering from what’s known as recency bias. According to the 2019 BeFi Barometer, which surveyed more than 300 financial advisers, recency bias is the most common bias advisers see when working with clients.

This fund run by a SAC Capital alum bought restaurant stocks amid the pandemic

restaurantPrentice Capital Management was up 6.6% for the first four months of the year, compared to the S&P 500's 9.3% decline and the Russell 2000's 21.1% decline. The HFRX Equity Hedge Index was down 9.4% for the quarter. Q1 2020 hedge fund letters, conferences and more Gross and net exposures In his first-quarter letter to Read More

Recency bias occurs when someone gives more weight to the importance of recent or memorable events, and it occurs in nearly every aspect of our lives. For example, are you familiar with the “hot hand?” Imagine your friend Joe is spinning a wheel for prizes, and on each of the last five spins, he’s landed on $10,000. He’s won $50,000 so far -- that’s a hot hand! Based on that recent success, Joe believes his chances of landing on the $10,000 spot will be high when he takes his next spin. But what he doesn’t realize is that each spin is an independent event, and his odds of landing on the $10,000 mark are no higher just because it happened five times in his recent past.

Buying High And Selling Low

When it comes to investing, it’s tempting to base decisions on recent market performance. If the market performs poorly, as it did in March, we perceive that it will continue to perform poorly, so it would be wise to sell. If the market is doing well, we anticipate that it will continue to do well, so it would be wise to buy. This way of chasing performance, however, isn’t logical, because it causes us to buy and sell at exactly the wrong times. Instead of buying low and selling high, which is the conventional wisdom, recency bias convinces us to buy high and sell low, resulting in poor portfolio performance.

A study that analyzed investor perceptions during the 2008-2009 financial crisis shows that recency bias may have been a factor that drove decision-making. The research showed that in the worst months of the crisis, investors’ return expectations and risk tolerance decreased, while their risk perceptions increased. As the crisis came to an end, return expectations, risk tolerance and risk perceptions improved.

In their haste to mitigate losses in a market downturn, investors who fall victim to recency bias tend to lose money. That very thing happened to a client of mine last month who was in the process of transferring a 401(k) account. Instead of completing the transfer and enabling us to invest during one of last month’s market dips, the client, fearing a loss, chose to wait, and instead lost out on the gains that came as the market started to recover a few days later.

Avoiding Recency Bias

It’s never easy to keep emotions in check during uncertain times. Without the proverbial crystal ball, we can’t predict the future, but it’s still tempting to try. For context, we’re likely to turn to information we can remember easily, and that’s usually information from our recent past. The next time you’re tempted to make a major alteration to your investment portfolio, consider these questions:

1. Is my focus too narrow?

If you’re basing an investment decision on news from recent weeks, or market performance during the past month, you need some historical perspective. For example, research by Dimensional Fund Advisors shows that since 1926, stocks have generally delivered strong returns over one, three and five-year periods following steep declines. Dimensional’s conclusion? Sticking with your plan helps put you in the best position to capture the recovery.

2. What’s my motivation?

If you’re making investment decisions based on fear or greed, it’s time to recalibrate. Take a deep breath, and remember what your investing goals were in the first place. Where are you on your journey toward those goals? If you have concerns, talk to your financial adviser and ask for an updated projection before taking action. Your adviser may be able to suggest other steps you can take to ensure you remain on track.

3. Who has a different opinion?

When faced with a decision, we often seek information that reinforces, instead of contradicts our opinion. Research credible experts whose opinions differ from yours; then try to understand their point of view and the evidence on which they make their arguments. Your opinions may change as a result of what you learn.

4. What would happen if I took action now?

Imagine a scenario in which you act on your feelings. Are you prepared if your decision leads to tax consequences or more losses?

5. If I’m selling (or buying), who’s buying (or selling) and why?

For every market transaction, there is a buyer and a seller. If you are considering selling everything and moving to cash, why would a potential buyer purchase what you sell? Try to imagine yourself in the opposite position, and develop an argument to counter the one you have in your mind. Doing so may help you expose flaws in your original thinking.

We all need accountability partners when it comes to making important decisions in our lives, and investing is no different. Taking a moment to test your thinking could make all the difference in your long-term financial well-being.