Recency bias, which is the tendency to overweight recent experiences, is a pitfall that many investors face. This article in the latest issue of Financial Planning gives some good examples of the risks of extrapolating recent events, or short term returns in the market, and drawing conclusions from them. For example, when the stock market goes up significantly over short periods of time, like the bull market in the late 90s, recency bias among investors has them believing those above average returns will continue in the future and as a result they buy when stocks are expensive only to see large losses when the bull market ends. The same holds true for the downside — when the market declines significantly, investors often time sell at the very worst time as they overweight the recent losses in stocks.
According to the article, a good way to combat recency bias is to “cultivate an accurate understanding of the long-term performance of various asset classes”. By comparing recent returns to the long-term historical returns, investors develop a fact-based way to judge the recent performance of a particular asset class and compare it to its historical, long-term performance in an effort to determine if the performance may or may not continue. See the chart below for historical asset class returns going back to 1926.
The authors of the piece outline five steps that professional advisors can take with their clients to overcome recency bias. These five steps could also be implemented by individual investors themselves to help overcome the urge to change course based on short term results.