Man is a product of his thoughts. We’ve all heard this phrase. It holds true for all aspects of our lives. Be it your choice for your preferred TV or airlines or a restaurant, it is your past experience that comes to the picture. The same goes true for investing as well. Recency bias is a phenomenon that affects many people and influences their trading decisions. We dig deep and explain to our readers the recency bias meaning in the easiest manner. Let’s begin!
What is recency bias?
Recency bias is a psychological phenomenon whereby a person can remember something which has happened to them recently in comparison to something which has happened to them somewhere in the past.
Also, to test this phenomenon, let’s consider the following example. Aniket is asked to recall the names of the 20 people he has met. He will thus be only able to remember the names of the people he has met recently than the ones he met long back.
Moreover, recency bias is a cognitive error. It happens to the human brain. This makes them remember the data of the events which have happened recently and forget the ones which have happened in the past. It is a common problem affecting most traders and investors.
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How does recency bias impact your investments?
This bias predicts the experience an investor might have in the future based on his past experience. It is thus considered one of the worst things to affect an investor. It makes the reality distorted for them whereby they select something and do something else.
As an example, consider a trader who has made a profit on 14 of the last 20 trades. There is a definite chance of him making an emotional mistake if he has lost on the last 4. Thus, it will eventually result in huge losses for him. On the contrary, if a trader has had a modest trade where he won 5 on the last 20 trades, where the last 5 trades went in his favor. He might be full of confidence and end up buying more aggressive shares, which might not be good.
Furthermore, this clutters the view of the investor. Trader thus makes his decision based on the recent events.
How can you overcome recency bias?
Moreover, investors are easily the victims of this bias. Also, most of the time they do not understand the reason for a sudden spike or fall in the markets and make their decisions based on momentary situations and emotions. This is thus the reason why shares are bought in a rising market and sold off in a falling market. Understanding the recency bias meaning is the most important part of correcting yourself.
Applying the following methods, one can overcome the recency bias
1. Avoid Short-sighted view: Always focus on the long term source and try to invest in the market with that view. Keeping a short term view will mean that you are restricting yourself to the 4 walls of the market. You might have knee jerk reaction at times. This makes you consider the most recent outcomes as the basis for choice, but you should keep the full picture in mind.
2. Work with things in your control: You should thus be in control of the assets under your command. Avoid bad investments in your transactions. Keeping realistic expectations will only help you reduce the mistakes. It is wise to remember that the recency bias works on your beliefs. You should consult the finance operators in case you have an investment business. They will cut down the risk for you.
3. Don't trust the latest performance: Wisdom says that smart investors do not get affected by the latest performances. You will have to understand that those numbers are just temporary figures. So committing a decision on the basis of such numbers might prove costly.
Recency bias is a brain illusion
Cyclicality is dependent on the ground to which it is being subjected. It is a rarity to find a smooth road all the time. You might have experienced a lot of ups and downs in your lives, but your choices should not be subject to such events. Thus, this bias is a brain illusion and your brain tricks you into believing that the same situation will exist in the coming time as well. Just like what happens in a desert with an oasis. You should seek assistance in case you are finding it difficult to let it go.
A True Story
In 2008, with the Lehman Brothers' crisis in the US, there was a mass panic in the US markets. Investors fell prey to the recency bias phenomena as per a study conducted by the University of California on 75,000 households. As per the report, people get swayed by the price rise in the markets and believe that it will continue to be so. However, the investors in their knee jerk reaction had to suffer huge losses. They were subsequently unable to take part in the 2009 rally. Furthermore, this is part of behavioral finance. It was also explained by Paul Krugman, the Nobel laureate.
Chasing Past Returns
One of the most disturbing biases in investing is chasing past returns. It is well known that past performance is not a parameter to gauge future returns. Despite this, investors fall into this trap of going by the past performance. Trend analysis can give you an idea but it is not necessarily applicable in the field of investing.
Conclusion
Recency bias is a common human problem that tends to impact the decisions we make. It is based on past events and plays in our minds. It is important to understand the recency bias meaning and follow certain measures like avoiding short-term view, making realistic goals, etc. besides other behavioral adjustments to bring this problem under control. You should consult financial advisors to make a better assessment of this problem and reduce its influence in your lives. Happy investing!
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