Have you fallen for the recency bias when it comes to investing?
Hopefully not, but it’s likely that many of us have done so in form or another at different times. But first, you may ask, what exactly is the “recency bias”.
The recency bias is a psychological phenomenon that causes us to focus more on more recent events vs. those that occurred in the past. In terms of investing, it can cause us to pay an otherwise inordinate amount of attention to the most recent events impacting market prices, while ignoring historical trends. This can cause unintended consequences.
The reason I’m thinking of this concept now is the reality of how the stock market has performed in recent years, considering where it was and where it is now.
The Decline
On March 9, 2009, the S&P 500 index closed at 676.53. This represented a continuation of a steep drop that saw significant paper wealth evaporate. The thing is, many people looked at this paper wealth as being “theirs”, and ended up feeling quite uneasy about continued losses. Thus, many folks ended up panicking and shifting their asset allocation to include less exposure to stocks and more exposure to “safer” alternatives. Even more drastic, some people bailed out altogether, seemingly thinking that the sky was falling.
Question for You: How were you feeling about stocks at the time? Did you change your investment strategy as a result, or at least consider it?
The Recovery
While many people have questions over the overall state of the economy, we should all be able to agree that the stock market has certainly recovered. On May 23, 2011 (most recent close) – 2 years and 2 months after being at 676.53 – the S&P 500 closed at 1317.37.
That’s a nearly 95% increase, in just over 2 years!
As I said, there are still questions on the economy, but I don’t hear nearly as much about people looking to flee the market out of fear of some kind of impending stock market doom.
Question for You: How do you feel about stocks today? How does your level of optimism/pessimism rate versus back in early 2009?
The Implications
If we looked at historical trends, that sudden and swift drop a few years ago might have appeared to be a buying opportunity. Stocks weren’t going to go down to no value, but there were people that suffered so much anguish over seeing their portfolio values evaporate that they got out of the market to gain peace of mind. Unless they soon bought back in right after, they missed out on the great bull market of the last 2 years. Thus, they would have taken a huge net loss.
This, to me, is an example of why it’s important to temper our thoughts and emotions about stocks and other investments and consider the historical data for context. This way, we can react in a calm, rational way rather than making rash moves that hurt us in the long run.
Thankfully I didn’t do anything foolish during that time with existing investments, but I did give it some thought. Ultimately, I stayed in the market with no change – though future earnings were treated more conservatively with a higher percentage of new savings put in cash. This probably cost me some capital gains.
Of course, nobody can totally predict the future, so who knows what will happen. That being said, are you more optimistic about the market today than a few years ago? Are you more likely to invest in stocks now, with peace of mind and optimism, versus back then?
So again, no predictions here, but I’m just saying…..those 95% 2-year returns seem great, but how many times has this happened before?
Personally, I think the recency bias is a good concept to keep in mind, with value in many situations – stocks, real estate, interpersonal relations, sports, and many others.
How did you answer the questions above, and how (if at all) have you been impacted by the recency bias?
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I stick with my asset allocation and dollar cost average into the market. I try to stay focused on the long term and not let daily news events and gyrations influence me.
krantcents recently posted..Is Networking Over for Job Seekers
krantcents – those are sound strategies to be sure. Always good to take notice of significant market trends and events too!
Recency bias happens a lot to the retail investor. It is a byproduct of human emotion and trading without a plan. I have to constantly remind myself to stick to my plan and not get caught up in greed or fear. For me, a plan includes having protective puts in place on all my stocks so I don’t have to sell in a moment of panic. I saw Silver Wheaton stock drop from over 43 to 34 in a matter of weeks but since I owned the 40 puts, I was able to sell. Now I am back in at a discount having sold at 40 and bought at 35.30.
Great article and reminder to have a plan.
optionsdude recently posted..Planning on Increasing My Silver Wheaton Position
optionsdude – thanks, glad you liked the article. I agree that it’s important to have a plan, no question.
When all that stuff happened, (Both the down and the up) I was in school and had 0 money to invest, However my dad always told me that you really need to “Steel up” and ride out the storm, because it probably will come back. If you dont, you’re buying high and selling low – a sure way to lose money.
Jeff @ Sustainable life blog recently posted..Changing Strategy
Jeff – that’s a good point your Dad made, and those who were able to be strong though that time ended up doing far better than those who sold low and then tried to re-enter the market later at a higher price point!
Unfortunately i believe this ‘recency bias’ which you talk about has more of an effect on the idiots that write the columns and ‘gurus’ who talk about the stock market and where it is headed. I often ignore most of what I read these days but I have a small selection of writers which write with any sense. One to keep in mind, make a buy or sell based on your own decisions and analysis and not what someone writes about in the news on a ‘Tips’ site.
Ricky recently posted..pension credit entitlement
Ricky – well, one would think so theoretically – but I suspect that many intelligent people fall for this as well. The concept applies in the realm of personal finance and other areas as well.
Stick to a investing strategy. It is good to be aware of what’s happening, but using that to time the market usually ends pretty bad!
During down periods, I don’t sell, I buy. Worked well so far!
Moneycone recently posted..If You Bank Online- You Need To Do This- Pronto!
Moneycone – dollar cost averaging at play there?
I stayed the course and quit checking my net worth every day.
It was hard to see the market dropping like that, but I kept adding to my 401k. Now that I’ve been through the dot com bubble and the great Recession, I think I have a handle on it. We’ll see if I can take better advantage of the drop next time.
retirebyforty – yes, it’s not worth checking net worth every day, that’s for sure:) I do agree that a long-term approach is best, though that doesn’t mean that we should turn a blind eye to what’s happening in the short term either.
I know that people have a tendency to to think that the markets will continue to be bullish when they are in a bull run and vice versa for a bear run. For some reason we forget that markets are cyclical just like business cycles.
Financial Success for Young Adults recently posted..How Young Adults Can Build Wealth
FSYA – yes, what you’re describing is the recency bias at play!
The markets are up a ton from the low, so it is time to be cautious. Doesn’t mean they won’t go higher, but the market has a history of pulling back too!
Robert @ The College Investor recently posted..Investing Tips from Personal Experience
Robert – yes, I agree that the market has a history of pulling back. Eternal bull markets don’t exist to my knowledge:)
Great article. It’s amazing where we are, two years later. It really felt the world was going to end. I recall several very calm co-workers snapping up shares like they were fish left on a beach. I thought they were crazy. Looking back, they were confident and saw opportunity. Kudos to them. Hopefully can be as calm and confident the next time around.
Buck Inspire recently posted..Tips To Finding Short Sale Properties
Buck – thanks, glad you like the article! Kudos to those coworkers you describe. I agree with you on being calm and confident the next time around.
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I think it’s important to look at stock charts of a variety of timelines — 7 days, 30 days, 6 months, 1 year, 5 years, 10 years — to paint a complete picture of how a given stock or index is faring.
Paula @ AffordAnything.org recently posted..A Tree Fell on our House Last Night
Paula – it’s important to consider the full picture of data, or at least a statistically signficant sample of it. Folks afflicted with the recency bias pay quite a bit more attention to what’s happening as of late vs. any time in the past. They’re missing out!
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