Recency bias: Will yesterday happen again tomorrow?
09 August 2018 | Topical insights
Commentary by James Norton, senior investment planner for Vanguard UK.
Assume you're driving in a foreign country for the first time. Along the way you pass an equal number of red and blue cars … but most of the blue cars are seen at the end of your journey. Experience suggests you're likely to think there are more blue cars than red ones on the road.
This is recency bias—our tendency to rely on recent experiences more than distant ones in predicting what will happen in the future.
Getting the popularity of car colours wrong would be inconsequential. However, when it comes to investing, recency bias can prove very costly indeed.
What goes up can go down (and vice versa)
In bull markets especially, forgetting the past can be dangerous for our wealth. When the market has risen, we often assume it will keep rising. Recency bias can cause us to forget that markets can also fall. We may become overly optimistic, increasing our risk exposure—possibly just as the markets move into overvalued territory. The technology boom of the 1990s was one classic example of this behaviour, resulting in devastating losses for many investors.
But recency bias doesn't just occur in rising markets. More recently, during the global financial crisis, stock markets were making the news on a daily basis, and despair was setting in. So although share prices had already fallen considerably, many investors assumed the downward trend would continue and took shelter by selling. But just like the markets have always done (sometimes it takes longer than others), they eventually settled and resumed their upward path. Those who had sold at the bottom risked realising losses with little chance of making them back.
In our chart below, the blue line shows the return of a hypothetical portfolio during and after the financial crisis. Half of the portfolio is invested in the FTSE 100, with the other half in UK bonds. We can see that from the top of the market in early 2008 to its nadir in 2009, this hypothetical investor lost around 20% of their portfolio. If they had panicked in 2009 and moved into cash (the orange line), by 2017 they would be down 16% on their initial investment.
The danger of selling out: Cumulative return of £100 invested at pre-crisis peak
Source: FTSE 100 Index and Bloomberg Barclays Sterling Aggregate Bond Index (rebalanced monthly). 100% cash represented by Bank of America Merrill Lynch GBP LIBOR 3 Month Constant Maturity Index. Data provided by Morningstar, Inc., and Vanguard calculations. Data as at 31 December 2016.
Recency bias is one instance in which age can be a real advantage. Those who invested through the tech boom and bust and the global financial crisis will likely have learned valuable lessons about patience. Those who have only started investing more recently should remember to take a long look in the rear-view mirror next time they're thinking of changing their strategy in response to a market downturn.
Senior investment planner, Vanguard UK
Investment risk information:
Past performance is not a reliable indicator of future results.
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Other important information:
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The opinions expressed in this article are those of the individual author and may not be representative of Vanguard Asset Management, Ltd.