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YOU’RE SITTING IN your favorite restaurant, feeling famished. The waiter arrives and reads a long list of mouth-watering specials. Yet the moment he walks away, all you can recall is the last item on the list.
Welcome to the recency effect.
In psychology, the recency effect refers to the human tendency, when asked to remember a long list of things, to have sharper recall of the final items. No doubt you’ve experienced this at a party. When introduced to 10 people, you only recall the name of the last one or two. The recency effect occurs in finance, too, though the consequences can be more serious than forgetting who the man in the blue shirt was.
Quite simply, if you’re making investment decisions based on what happened in the financial markets in the last week or the last day, you risk chasing past winners or perceiving as the greatest risk something that’s already occurred and is already reflected in market prices. We’ve seen that in 2020, with many people turning defensive in March at the peak of the coronavirus crisis, only to see stocks and other riskier assets bounce back sharply in this year’s second quarter.
There’s an evolutionary reason for the recency effect. Thanks to our hunter-gatherer ancestors, our brains are programmed to respond to what we perceive as the most immediate threats. At the same time, we are likely to see the best opportunities as those that proved fruitful in the immediate past.
During particularly traumatic markets or, alternatively, during rampant bull markets, this effect can be magnified. Our short-term memories dominate our decision-making, prompting us to extrapolate recent returns into the future.
The consequence: People often buy stocks at or near the top of the market cycle and sell at or near the bottom. In bull markets, this equates to fear of missing out, while in bear markets the overwhelming imperative is loss aversion.
In response to those who warn of the recency effect, folks will claim that this time is different. They’ll argue something fundamentally has changed in the markets and a more tactical approach is required.
The problem with this argument: While every crisis is certainly different in one way or another, that doesn’t make it any wiser for investors to base their strategy on what might have worked the last time around. Indeed, this can end up resembling a game of whack-a-mole, where the participant tries—usually in vain—to push rapidly appearing individual moles back into a hole by hitting them over the head with a mallet. As each mole withdraws, another one pops up somewhere else.
How do we resist the impulse to put the greatest weight in our investment decision-making on what happened last? The answer, I believe, lies in asset allocation and rebalancing. By far the biggest influence on our investment performance is how we distribute our money across growth and defensive assets. That allocation should, in turn, be driven by our risk appetite, goals and individual circumstances.
If you decide in a rational moment that your desired allocation is 50% growth (stocks, real estate) and 50% defensive (bonds, cash), then that’s what you should stick with. If share prices drop, your allocation may look more like 45%-55%. If you respond to the market fall by selling stocks and buying bonds, you might end up with 40%-60%.
In other words, the recency effect can drive you away from your target portfolio by encouraging you to change strategy based on information that’s nothing more than a small sample size delivered over a brief period. This is like a pilot who reacts to turbulence by completely changing course.
A better response is to rebalance. If stocks have fallen sharply, you should sell some bonds and buy stocks to get your desired asset allocation back on target. Likewise, if stocks have done well, you should sell some stocks and buy bonds.
The important point: Your investment decisions should be based on your risk appetite, goals and circumstances, not on what happened in the markets over the past quarter and what you think will happen next. So put the mallet away. There will always be a mole popping up somewhere. Just leave the little rascals alone.
Robin Powell is an award-winning journalist. He’s a campaigner for positive change in global investing, advocating for better investor education and greater transparency. Robin is the editor of The Evidence-Based Investor, which is where a version of this article first appeared. Regis Media owns the copyright to the above article, which can’t be republished without permission. Robin’s previous articles include No Need to Guess, What’s the Plan and The Good Advisor. Follow Robin on Twitter @RobinJPowell.
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Great post on a very important point. Some people go a little further and create a personal investment document to refer to in moments of stress. I have my own, which is only partly written down. In either case, I think you’re very much on the right track.
My personal view is that if you truly understand your AA – why your stock/bond split is what it is, what are your exact holding and why do you hold them? What makes your portfolio so great for the long term? Inflation? Deflation? Crashes? Booms? Rate increase? Rate Decreases? If you understand that, I think it makes it so much easier to stay the course.