How memories of market crashes could be clouding your judgment now.
When making investing decisions, it may seem like we have to predict the future. Unless you have a secret time machine, it’s an impossible task. When we’re faced with difficult decisions, especially during times of uncertainty and volatility, our minds take shortcuts. For example, when we are trying to predict the future, our minds naturally reach for what happened most recently–that’s called recency bias.
As humans, we have an easier time remembering what happened most recently. This shortcut serves us well in other aspects of our lives, but it can hurt us when making investing decisions. Recency bias can prompt us to place undue importance on recent events. When we see our portfolio drop 10%, recency bias convinces us that it will just keep on dropping.
What Recency Bias Looks Like in Investing Decisions
Basing investment decisions on recent performance can get any investor in trouble, but research suggests that recency bias prompts many people to use this strategy. In a study that looked at the trading decisions of individual investors at a large national discount broker and a large retail broker, researchers found that investors’ buying decisions seemed to be swayed by the past returns of investments. The investments bought by investors outperformed the market by 40 percentage points over the two years prior to their purchase. In the long run, this strategy didn’t quite work out for the investors in the study. Researchers found that the stocks investors sold subsequentlyoutperformed those they bought in the ensuing months.
During the 2008 financial crisis, many investors seemed to fall into the trap of recency bias. Using survey data and trading records of investors during the 2008 crisis, researchers found that recent stock market performance fueled investor trading behavior–prompting them to trade more during that volatile time. The study also found that increased trading activity during the 2008 crisis did hurt investors’ overall performance, above and beyond the existing market volatility. These findings have also replicated in normal market conditions, where researchers found that high trading levels resulted in poor portfolio performance.
How to Stop Recency Bias From Impacting Your Decisions
Although we haven’t seen the same flight away from the market that occurred during the 2008 crisis, as market volatility continues, it may become harder to resist the pitfall of recency bias. There are various techniques investors can use to avoid their biases when making decisions. Interventions to combat recency bias can be organized in two different approaches: one focused on managing relevant information and the other on slowing down the decision-making process.
Filtering Out the Noise to Focus on What’s Important
Before making any important decisions, surrounding yourself with the right information and resources is essential, but that can be hard to do during volatility. When the market is dropping, our minds have a hard time looking past what is happening right now. Implementing a few key techniques during times like these can help you incorporate the right information at the right time.
1. See the full picture: During a market crash, it can be difficult to remember that market declines are fairly regular occurrences. Researchers recently tracked market crashes over nearly 150 years and found that they occurred about every nine years.
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The chart below shows the real monthly U.S. stock market returns going back to January 1886 and annual returns over the period of 1871-85. Each horizontal line indicates a market crash and connects the episode’s peak cumulative value to when the cumulative value recovers. Paying attention to charts like this during volatility can help us remember that, while the market’s road can be bumpy for investors, it’s a ride worth taking. Although we can’t predict the future, the U.S. market has eventually rebounded in the past.
2. Set an information schedule: Receiving constant market updates can swayeven the most skilled investor. During times of market volatility, try setting a schedule for how often you check your portfolio and the news. Once you make sure your portfolio is aligned with your goals, try checking it only once a quarter (and stick to this schedule even when markets have gone awry). When it comes to catching up with recent events, try checking the news once at the end of the day, or even just once a week.
When All Else Fails, Just Slow Down
Recency bias is a tricky one to spot. That’s because our minds work so quickly, and we often don’t notice just how much we are being swayed by recent events. During times like these, it can help to slow down the decision-making process to give our conscious mind more time to evaluate.
3. Add friction to the decision: Before making a hasty decision, calculate the tax consequences (assuming you’re still facing a gain) or transaction fees of the proposed trade. In an online experiment, researchers found that many investors hate paying taxes even more than they dislike the prospect of losing value in a further market downturn.
4. Explain the opposite: If you’re set on selling an investment, try to explainwhy a person might be willing to buy your securities. What might a person’s reaction be when your investment pops up on their screen at such a discounted price? If you were in their shoes, what might you do? Forcing yourself to answer questions like these before making investing decisions can help you see past your biases.
Preparing for Our Biases
When it comes to making investing decisions during volatility, we have to remember that we are only human. As humans, we all have biases that can lead us astray when making investing decisions. Incorporating a more thoughtful decision-making process when it comes to your finances may help you avoid falling prey to your biases when it matters most.
(This article draws from our recent guide that discusses the range of biases that can hurt us during volatility and a set of interventions we can implement to make more logical investing decisions. The guide was originally written for financial professionals working with investors, but it provides those same insights and ideas directly for individual investors as well.)