Recency Bias
Recency bias is not a term you often hear in the investment world, but I have read about it and seen other people experience this thought process when it comes to investing in the markets. I believe recency bias is one of the causes of why so many people sabotage their investments by “buying high and selling low.”
Recency bias is simply viewing the recent returns of the market or a particular asset class as if this trend will continue indefinitely. Recency bias can occur whether the market’s recent trend has been up or down. You probably do not understand how anyone could think this way, but many people do. In fact I would argue that most retail investors think this way more often than not. Otherwise how would we ever get stock or real estate bubbles and busts?
Although recency bias is practiced on an individual level, it is influenced by the group think of the markets. We only have to look at last decade’s real estate boom and bust to see how recency bias was engaged in (and still is) by a large swath of the investing public.
Think back to the years 2002 to 2006 when real estate prices were increasing significantly every year. All I heard from everyone was real estate never goes down in value and it is a “sure thing” and I had better get in before I got left behind. This thinking was recency bias practiced on a scale I had never seen before. It was caused by the fact that for about 4 or 5 years real estate prices went up with no end in sight. People began to believe this was the way real estate prices would always behave.
A few of us used our common sense. With real estate prices increasing 15% to 20% per year and incomes essentially stagnant, I told many people that this could not continue and that real estate prices were likely to fall hard. But at the time most people could not see this happening. Real estate prices were going up and they thought it would continue to go up, albeit maybe at a slower pace.
Of course we all know what happened. In 2008 and 2009 the real estate bubble burst and prices fell sharply. And now in the real estate market I am seeing recency bias on the down side. A number of people have recently told me that real estate is a bad and/or risky investment and that they would never invest in real estate.
Upon hearing this I suggested to some of these people that, yes real estate has had a few bad years and prices will likely not turn upwards for several more years, but real estate is now a much better value than stocks or bonds (especially bonds, which I believe are now in a significant bubble).
But the people I suggest this to just do not agree. One acquaintance told me, “I have learned my lesson; I will never invest in real estate again.” When I heard this, I thought back to my disastrous real estate ventures in California in the 1980s. And then I thought about what my life would be like today if I had adopted that same viewpoint. That is, after having been burned in real estate in the late 1980s, what if I had been too afraid to invest in real estate in the 1990s? If I had been too afraid, I am sure my wife and I would not be retired today and we likely would be working past age 70.
Anyway, my acquaintance’s mind-set (i.e., recency bias) can cause people, even those with good paying jobs, to work their entire lives and still wonder whether they will be able to retire. The main reason this happens is because, after a bad experience with a certain investment, people shy away from that investment. By the time people get their courage back, the investment has usually recovered and they end up buying the investment at much higher prices (which represent much lower valuations). Many times the investment tanks again and people get fearful and sell again at lower prices. And the “buy high and sell low” cycle just completed, starts over again.
Recency bias has also taken place in the stock market. Since the 2008-2009 financial crisis, the amount of money moved out of stock mutual funds and into bond funds by retail investors has been staggering. Most of the stock market action the last couple years has been driven by institutional and wealthy investors.
I will be the first to admit that there seem to be perils everywhere that can affect your investments.
- The European debt crisis could unravel at any time,
- The US has their “fiscal cliff” to deal with later this year,
- Another area in the US budget that has gotten very little recent press is the Washington politicians will have to deal with another debt ceiling battle in January,
- US job security is anything but secure,
- The world economy is slowing down,
- Chaos in the middle east,
- Major developed countries currencies’ are being devalued daily.
There is plenty to be concerned about. But no one knows what is going to happen in the future. Despite all the economic threats lurking on the global stage, I think you should still maintain a diversified investment portfolio. For example, I have recently added shares to a few of my European stock positions which have dropped in price (but only because they are global companies and their current dividends are yielding over 5%). This is another example of “doing the opposite of what everyone else does.”
If all the investing dangers are keeping you awake at night, then I think you should cut down your exposure to the equity markets. But I do not think you should go to 100% cash.
The only people who should be in 100% cash are people who already have so much money, they cannot possibly outlive it. These people have no reason to take any risks in today’s market environment. I suspect no one reading this blog falls into that category.
I know investing has been very difficult the last few years and people have lost a lot of money, but you should not let your recent experiences in the markets change your long term investing strategy. In other words, don’t engage in “Recency Bias.”
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