Understanding Recency Bias and its effects on the decision-making process

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18 May 2024

Introduction

Recency bias refers to a cognitive bias where an individual provides higher importance to recent events compared to what happened before. Since recent events or trends are easier to discern than what happened in the past, or what is likely to happen in the future, individuals tend to fall into the trap of recency bias depriving him/her of making fruitful decisions that could have otherwise turned out to be productive in the given circumstance.

Let us suppose that an event has taken place recently and compare it with the event that happened four years ago. When it comes to decision-making, more weightage will be provided to the event that happened recently and less to the one previously. No matter how crucial the event was, which occurred four years ago, our human brain tends to reflect the cognitive error due to the recency bias as the recent events are easy to recall. It is crucial to take into consideration the impact created by recency bias as it can have some serious consequences on our investment and financial decisions.

As humans, we tend to give high preference to readily accessible information instead of adopting the path of less accessible cognitive activities like doing hard work, analyzing, and thinking. Instead, we fall prey to the information that requires less of our effort to perceive such as diagrams, explanations, and interpretations. As a result, we lack the spirit of going the extra mile to truly analyze the circumstance that we are facing and we provide high priority to cognitive ease, leading us to errors or biases in our decision-making.

Hence, we overweight recent information or trends without even considering their probable impact or outcome in the long run. As a widely studied topic in behavioral economics and behavioral finance, recency bias is closely related to the trait showcased by the hot hand fallacy. An individual tends to give less priority to finding out whether the events recently occurred are even relevant or reliable or is it the impact of recency bias that one is providing high emphasis to such events?

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How Does Recency Bias Impact Investment Decision-Making Process?

When it comes to investing, recency bias is one of the hardest cognitive biases to avoid. Hence, it impacts the decision-making of investors leading them to make irrational and screwed investments which will be briefly listed down below.

Recency bias leads investors to not accurately evaluate economic cycles in the market. Due to this they refrain themselves to not buying in the bear market as they become pessimistic about the recovery of the market. Further, they remain invested in the bull market and ignore the fact that the cycle does not continue the same, the stock market experiences ups and downs. Hence, they ultimately miss the opportunity to buy at a discounted rate in the bear market and not timely exit the bull market to book the profit, which would have leveraged them anyway.
Due to recency bias, investors possess the belief that the bull run of the market is likely to continue. The same goes for their thought belief in the bear market as they tend to think the market is likely to keep falling. Therefore, investors make decisions based on their emotions which erodes their potential earning. As a result, they hold the stock too long or exit from the market too soon. Either of the scenarios has negative implications for them.
Investors follow the hot trend, as depicted by the impact of the hot hand fallacy among the investors. It is because investors believe the lucrative string of successes is likely to continue. As a result, they tend to prefer the fund managers who have a hot hand in the market, implying they have recently outperformed the market through his/her exceptional tactic to garner returns for their investors over several years. Hence, they believe the fund manager is likely to have a continued winning streak and ignore the fact that future outcomes are independent of past occurrences and depend on how they will perform in the future.
Investors overweigh the recent events or headlines occurring in the investment world, which impact their investment or trading decisions. For instance, they assume that a bearish trend is likely to continue in instances like a market crash. However, it is for sure that the market will bounce back, or the drop-down of the stocks might be the correction to go further up in the coming days. The facts are denied in this scenario and the latest events that occurred have been given more priority by a trader or investor. Further, investors do not realize the bubble and ignore the fact that price has reached way above its fundamentals, and they continue buying the asset in the hope that the market will continue to grow further.
Justifying it through a perfect example of financial services, in 2019, financial services was amongst the best-performing sectors in the S & P 500 index delivering an exceptional return of about 32%. Hence, investors chased it as the hot investment trend and piled up their portfolios with the allocation of financial services stocks. However, it turned out to be a disappointment for them as financial services stocks returned negatively with a return of -2 % in 2020 them. May it be recency bias or hot hand fallacy, it created some serious consequences for investors.
Getting back to the priority given to recent events, suppose, you invested $2000 through thorough analysis comprising of 4-5 stocks in the portfolio. Further, you managed to gain a return of $4500 over four years. Then in the last six months, your value falls down to $4000 only. In this case, you booked a profit of $2500 over the course of four years and managed to book a loss of $500 in the last six months. Due to the recency bias, you tend to give high priority to the loss of $500 in the last six months and less priority to the profit of $2500 you gathered over the period of four years. It is to be noted that actually, you are still on a profit of $2000. Due to recency bias, recent events get overweight on investors’ minds.
Investors tend to favor the short-term performance of stocks rather than their long-term performance, a very common trait reflected due to recency bias. What should be taken into concern is, short-term performance does not reflect the real worth or potential of stocks. Instead, long-term performance based on the dividend potential, the trend of EPS, incline, or decline in net profit over the years are some of the many indicators to track whether the stock is performing better or not, over the years.
Since the price of stocks or assets tends to follow the cycle, the fund or stock that performed well in the past may not necessarily perform better in the future. Instead, one who performed exceptionally in the past has a high probability of performing below expectations in the future since the price of stocks or assets moves in cycles. If there is a peak, it will experience a downfall as well no matter if it is for the correction to make another peak in the market. However, investors with recency bias tend to think lucrative stocks in the past are likely to continue which leads them to purchase it at a premium price ultimately impacting them in terms of profit margin as it gets reduced since they bought it at the peak.
Recency bias leads the investor to be dependent on a very small sample size. For instance, the track record of the last 3-4 months creates biases in their investment decision as their trend prediction may not be applicable to the bigger picture.
Investors tend to neglect fundamental analysis, one of the vital analyses an investor needs to prioritize. As fundamental analysis can let the investor know the real fundamental value of a particular stock, an investor could purchase the stock at the time of its highest valuation, which is a dangerous strategy indeed, when they lack the skill of fundamental analysis. It makes them devoid of long-term success.

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How to Avoid Recency Bias?

One of the toughest cognitive biases to counteract, it’s all about the game of fear and greed based on an investor’s emotions and a brain illusion. However, an investor can follow certain tactics to try his/her best to overcome it to the extent s/he can, based on the suggestions listed below.

Dig the concept deep inside your brain that the stock or equity market works in a cycle. If there exists a bearish market, so does the bullish market. If a stock’s price goes up, it dips down for correction as well. Eventually, the market will go up in the long run despite the fact it fluctuates in the short run.
One must not get carried away by personal prejudices and judgments, instead, consult a financial advisor or someone who possesses enormous experience in the field of finance and investment before taking any sort of investment step.
One must try to see a larger picture and make predictions based on larger data and trends for better decision-making and try to get rid of myopic view of the financial market.
Try to analyze the fundamental worth of the stock so that you do not buy an asset or stock when it gets overvalued. For this, a fundamental analysis of the stocks is what you should consider based on the various financial indicators.
Set a financial goal and a rigid investment plan and do not deviate from it so that you stay in line with your vision for what you have targeted in the coming years. It helps you not to get affected by recent events in the market and you will stay focused on the financial goals you defined and make investments accordingly.

Does Expert Recommendation Minimize Recency Bias?

A study conducted by Dedhy Sulistiawan and Riesanti Edie Wijaya in 2015 funded by The Ministry of Higher Education in Indonesia, found that expert recommendation helps minimizing recency bias. Two scenarios were tested, one good news followed by bad news and other bad news followed by good news based on the concept of sequential information. What the study found out is, that investors overvalue the stocks when the last information they receive is good news and tend to consider good news as their last information in the scenario bad news followed by good news and vice-versa. As the study was performed mainly to study the impact of recency bias in a group, it provides evidence to the readers that expert recommendation does minimize recency bias in groups.

Are Emotions Exacerbating Recency Bias?

The study conducted by Felizia Arni Rudiawarni and Bambang Tjahjadi in 2020 published in International Journal Trade and Global Markets, tested whether emotions affect the recency bias in judgment and decision-making and found that the effect of recency bias was so strong that emotions did not affect the recency bias during decision making. Further, individuals weighed negative information more heavily than positive information leading them to irrational decisions. Panic selling can be considered as one of the examples.

Conclusion

Since recency bias is one of the toughest cognitive biases to avoid in the field of investing, one must provide high emphasis on how it impacts his/her investment decision-making and have the possible tactics on hand so that you can avoid it when you gets an instinct that you are following the path of recency bias. In-depth knowledge of the financial world and its working mechanism can help an investor a lot to cope with the recency bias. However, s/he should polish her skills on a day-to-day basis as every day is a new learning opportunity, and adding some extra concepts or skills to your checklist can turn out beneficial to you in the long run, as an investor. You indeed get different viewpoints regarding recency bias, however, it’s all up to you how you perceive it and what methods work best for you to mitigate its consequences.

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