“Why would I own anything other than the S&P 500?”
“I’m thinking of putting my entire retirement nest egg in the S&P 500 and calling it good.”
“I don’t want to own any international stocks. They haven’t performed very well.”
“AI stocks have been on fire; I’m going to only buy those stocks going forward.”
These are the very real comments one hears during a stretch where the S&P 500 has been a juggernaut…
Source: Koyfin
The above chart shows the total return of S&P 500 (SPX, orange) vs. several other equity asset classes over the past 10 years (small cap IWM blue, real estate VNQ red, international VEA yellow, emerging markets VWO green). There have been a few bumps along the way, but U.S. large caps have been a standout vs. other equity asset classes over the past decade. It’s not hard to see why there’s almost a cult-like allegiance to the S&P 500 as recent returns have been historically exceptional.
Most investors want to get while the getting is good. What’s the big deal?
There’s a name for this behavior and it’s quite possibly the most dangerous bias an investor could have…
Recency bias
Recency bias is a predisposition to recall and emphasize recent events and/or observations and to extrapolate patterns where none exist. Recency bias runs rampant during the bull markets, when many investors wrongly presume the best performing stocks—most recently technology & U.S. large caps—would continue to gain indefinitely. (Source: CFA Institute)
In simple terms, investors tend to overweight what just happened and think the current conditions, trends, and outperformers will continue in the future.
The stock market is racing higher, let’s pile in and let the good times roll!
The stock market is plummeting, let’s sell everything and wait this out. I don’t see how things can get better.
The phenomenon doesn’t exclusively apply to investing. A sports bettor might say, “Alabama just beat Georgia, there’s no way they’re losing to Vanderbilt!”
(Bama would go on to lose to the following week to Vanderbilt).
What makes recency bias dangerous for the investor?
Recency bias is dangerous in investing because it leads investors to make decisions based on recent events or performance, rather than considering long-term trends and fundamentals.
- Overemphasis on short-term stock movements: Investors affected by recency bias tend to place importance on the most recent market movements or stock performance, extrapolating these trends into the future. This can result in chasing “hot” investments or sectors that have performed well recently or panic selling during difficult markets and unable to comprehend how things could get better.
- Ignoring historical data: Recency bias causes investors to shun historical data. This can lead to making investment decisions without a proper understanding of broader context.
- Impulsive decision-making: Recency bias can prompt investors to make hasty, emotionally driven decisions in response to recent market events, such as panic-selling during a downturn or buying aggressively during a market rally.
- Overconfidence and herd behavior: Investors affected by recency bias may become overconfident in their ability to predict future market trends, leading them to make riskier investments or follow the crowd, rather than relying on sound investment principles.
- Missed opportunities: By focusing too heavily on the most recent performance, investors may overlook promising investment opportunities that are out of favor.
How can an investor fight recency bias?
- Adopt a long-term perspective: Focus on long-term trends, market cycles, and fundamental analysis rather than being swayed by recent short-term performance or events. Avoid extrapolating recent experiences into the future.
- Diversify your investments: Spread your investments across a broad range of asset classes, sectors, and geographies to reduce the impact of recency bias on any single asset class, sector, or individual stock.
- Manage position sizing: Establish a rebalancing schedule to maintain your target asset allocation. For individual stocks, it’s perfectly reasonable to cap a position size to ~10% of your investable assets.
- Get in touch with history: Understand that nothing lasts forever, what’s in favor will become out of favor (and vice versa). Shun short-term forecasts or getting caught up in today’s hot themes.
- Maintain an investment journal: Document your investment rationale and decision-making process. Regularly review this journal to identify and address patterns of recency bias in your decision-making.
- Implement rules-based investing: Consider adopting a systematic, rules-based investment approach that reduces the influence of emotions and biases.
We bring recency bias up because we see it everywhere in potential/existing clients. Getting in tune with your biases can save you from making a big mistake.
As the great Ice Cube once said, “Check yourself before you wreck yourself.”