RECENCY BIAS: STAYING RATIONAL DURING MARKET VOLATILITY

Have you been tempted to invest more in stocks when the market is doing well? Do you suddenly want to sell out of stocks when the market is doing poorly? If you tend to overemphasize recent events like the gains or losses from past performance, you are being influenced by what psychologists call “recency bias,” or the recency effect.

When your memory lends greater significance to the impact those recent events may have had while ignoring the broader context, you may not be considering their objective probability over time.

For an investor, this unconscious bias can lead to rash responses and poor trading decisions when financial markets get volatile. But how can you avoid its influence on your decision-making process?

In this article, we’ll take a closer look at how recency biases can impact financial planning before diving into a few tactics for overcoming these tendencies in your investment strategy.

UNDERSTANDING RECENCY BIAS

It is easy to be drawn into a sense of alarm by the financial news when financial markets are volatile.  And the risks associated with short-term market volatility do make the stock market a bad place to invest money that you plan to use in the near future. But if you are investing for the long term, say for your retirement, you need to remember that even though past performance doesn’t guarantee future results, historically over time, the stock market has gone up more than it has gone down.

That fact doesn’t create painful experiences that lodge in your memory, so it’s not as “available” to you – hence why the recency effect is closely related to another source of mental mistakes known as “availability bias.” Another term for this cognitive bias is “availability heuristic.” This emphasizes the mental shortcut our brains create to recall our personal examples as context for future predictions.

Making decisions that are influenced by the recent past or available memory can lead you to miss out on that growth potential. But if you can ride out the short-term cycles, the long-term potential returns from stock market investing can be significantly higher than from investments in cash or bonds.

So, how do we rewire our brains to look past our recent experience?

OVERCOMING RECENCY BIAS IN FINANCIAL DECISION-MAKING

Understanding recency bias is the first step, but kicking any kind of behavioral bias is no easy feat. It’s crucial to work on developing an investor mindset that prioritizes long-term objectives over short-term fluctuations.

Here are a few strategies you can use to avoid making emotional investment decisions:

1. DIVERSIFICATION AND LONG-TERM PLANNING

Diversification is a key piece of any resilient investment strategy, particularly when it comes to countering the effects of recency bias. By spreading investments across various asset classes, you reduce the impact of any single market event on your overall portfolio. This approach not only helps mitigate risk, but also helps maintain a steady course toward your long-term financial goals, regardless of short-term market fluctuations.

Long-term planning is equally critical in overcoming recency bias. By setting clear financial goals and creating a roadmap designed to achieve them, you can stay focused on the bigger picture. This perspective helps you resist the temptation to make knee-jerk reactions to recent market movements, reinforcing the importance of sticking to a disciplined investment strategy.

2. SYSTEMATIC INVESTMENT STRATEGIES

To minimize the risk of fear, anxiety – or even excitement – influencing your decision-making process, it helps to create a systematic strategy. For instance, committing to investing a fixed amount at regular intervals helps remove the emotional element of chasing peaks and valleys.

Another critical part of systematic investing is rebalancing your portfolio. Over time, it’s common for gains and losses to cause a disproportionate weight across assets and classes. By periodically adjusting your asset allocation to maintain your desired risk level, you can create a disciplined approach that can counteract the natural inclination to chase recent gains or avoid recent losses.

3. HISTORICAL DATA ANALYSIS

Analyzing historical data allows you to literally look past recent performance to examine long-term market trends. With valuable insights into how different asset classes perform over time, this approach can help guide your diversification strategy, helping to position your portfolio to withstand volatility. You also gain a broader perspective on market behavior, reinforcing the idea that short-term fluctuations are just part of a larger, cyclical pattern.

4. SCENARIO PLANNING

Scenario planning helps you prepare for a range of potential market conditions by visualizing how different factors – such as economic shifts, interest rate changes or geopolitical events – might impact your portfolio. Considering these various situations, both positive and negative, enables you to develop contingency plans and respond thoughtfully, rather than react impulsively to market changes.

This preparation can provide a sense of stability and confidence, knowing that your investment strategy has built-in flexibility to adapt to a wide range of outcomes. As a result, you are more likely to stay the course, maintaining focus on your overarching financial objectives despite short-term market fluctuations.

5. REGULAR PORTFOLIO REVIEWS

Last but not least, regular portfolio reviews are essential for maintaining a healthy investment strategy. While it might be tempting to view recent performance in a vacuum, consistently assessing your portfolio’s performance allows you to view it in terms of your long-term financial goals and risk tolerance. It’s important to treat these reviews as check-ins rather than a strategy refresh.

Use them to identify overexposure to particular asset classes resulting from recent market movements. Or reassess your financial situation based on big life changes, such as a new job, a new family member or if you’re nearing retirement.

Moreover, working with a financial planner during these reviews can help you sidestep this behavioral finance investing trap. A planner can help you maintain an objective perspective, working to ensure you’re making decisions based on data and long-term goals rather than emotional reactions to recent market events. They can also provide a broader market outlook, helping you navigate potential challenges and opportunities.

If you have questions about your portfolio or are considering taking your money out sooner than expected, you and your planner can discuss and decide what is appropriate for you based on your long-term goals. If you don’t have a planner, contact us for a no-obligation review of your situation. We’ll connect you with a planner who will listen to your goals, help you avoid recency bias and assist you in creating a financial plan for your future.