Combatting Recency Bias: A Step Towards A Wealth Building Strategy

At LPL Research, we believe one of the keys to successful investing rests with our own individual ability to overcome basic human tendencies and emotions.  Some of these tendencies have been defined and are part of the research umbrella we now call behavioral finance or behavioral economics.

In this latest edition of LPL Street View, Chief Investment Officer Marc Zabicki unpacks one of those tendencies we call “recency bias.”  This is the human inclination to place too much emphasis on experiences that are freshest in our memories.  In the world of investing, it can mean assuming market returns or market conditions in one quarter or one year will continue into the subsequent period.

We believe one way to combat recency bias is to constantly recall that financial market decision-makers are prone to irrational behavior.  It’s human nature to be irrational at times—even professional investors can fall victim if they are not careful.  Because market prices can vary materially from rational equilibrium at times, extrapolating recent market returns into the next period can often be a mistake.  It’s a good idea for investors to engage in some rational homework to assess if recent market returns are in line with developing fundamentals or if they have been influenced by irrational sentiment.

Another way to combat recency bias is to adopt a contrarian investing approach.  An individual adopting a contrarian approach often looks for market opportunities that go against consensus or against current market sentiment.  However, we have to be careful of blindly adopting a contrarian approach. We have to do our homework as well. Paying close attention to price deviations from the norm can often lay the foundation for a good contrarian decision.

Finally, and perhaps the easiest way to combat recency bias—have a plan.  If you have decided to set aside tactical asset allocation in favor of a systematic, longer-term investing strategy, (one that rebalances toward an out-of-favor asset class on a quarterly or annual basis) the effect of recency bias on your portfolio may be minimized.  In fact, having a plan and sticking steadfastly to it may be the easiest and most effective tonic against various human biases.

Regardless of your approach, we believe combatting recency bias and/or other human tendencies is an important step toward the development of a formidable wealth-building strategy. 

You may also be interested in:

• What Do Munis, Fed Rate Hikes, and the 80s Have in Common? – December 1, 2022
• Three Things to Know About Recessions – November 10, 2022
• Could Things Start Looking Up for the Bond Market? – October 27, 2022