How to manage recency bias
Oran Hall, Personal Financial Adviser
It is quite common to make personal financial and other decisions on the basis of recent events. So often, though, such decisions are not necessarily consistent with the best long-term interests of the decision maker.
We will look, today, at how to manage the risks associated with recency bias.
Have you ever noticed how investors often rush to buy stock when the stock market is advancing or to sell when it is falling? Some persons even go beyond that.
When they decide to buy stocks, they tend to ask which ones have advanced recently or even which have advanced the most recently.
Recency bias extends beyond the stock market. It affects other markets such as the real estate market and the foreign exchange market, for example.
To reduce the tendency to make decisions based on recent personal experiences and recent market behaviour, it is critically important to have a solid reason for making decisions grounded in a plan. If the plan speaks to long-term goals, decisions should revolve around the achievement of such goals.
In such cases, short-term developments should not interfere with such plans. It is quite true that many persons act the way they do because of short-term risk aversion, which blinds them to the long-term consequences of their action, particularly the likely derailment of their long-term goals.
The next time the temptation to divest the ownership of stocks arises, careful consideration should be made of how the market and particular stocks have behaved, not the immediate past, but over an extended period in the past, five years or so.
Such an examination will likely reveal the see-saw behaviour of both over that time, revealing that, generally, periods of decline were generally followed by sustained periods of advance, strong advance, sometimes. Truth be told, our stock market has forgotten how to do so.
Nonetheless, reducing or liquidating a position to repurchase later often fails for many reasons including the failure to reacquire at a price that makes sense relative to the price it was sold at as well as the additional costs incurred in selling and re-purchasing.
Rather than just looking at the current market situation, it is important to look at the long-term potential of the particular investment instrument and of the market itself. Markets do not move in a linear way, so allowance must be made for periods of decline, which may result from profit-taking or developments in the market, some of which may be very short term.
The issue of seasonality should also be considered when making decisions. With respect to the stock market, for example, the market tends to slow down in the summer months largely because fund managers and other influential market participants tend to be on vacation and thus tend to be less active. Additionally, market performance tends to be lacklustre in the weeks prior to the annual budget as investors and other decision makers take a wait-and-see approach to business and investment.
On the other hand, year-end activity tends to be more robust as fund managers act to boost the performance of the funds they manage. January also tends to see strong market activity.
It is useful to have a balanced and well-diversified portfolio to reduce the temptation to make knee-jerk responses to developments in any of the financial markets.
Many investors rely too heavily on timing the market. I do not know anybody who has the ability to consistently say where the market will go and when. Market movements consistently make experts look not so expert at all.
That being the case, not much focus should be placed on timing when to buy or sell. Selecting solid investment instruments and, more importantly, having an appropriate portfolio mix are more certain ways to achieve investment goals.
Where possible, buying a set dollar value of particular instruments on a systematic basis is an approach that can be used to build a portfolio that helps the investor to benefit from the fluctuations of the market.
Having said all of the above, there are times when it is necessary to respond to recent developments in the financial markets. Research and history may suggest that these recent developments could have unfavourable consequences over an extended period. Prudence in such cases would suggest taking action to protect the value of the portfolio.
Investors whose goals are clear and well defined, who do adequate research, devote reasonable time to manage their portfolios and are able to keep their head level should be better able to manage their portfolios effectively without being distracted by recent and often short term developments in the financial markets.
Oran A. Hall, a member of the Caribbean Financial Planning Association and principal author of 'The Handbook of Personal Financial Planning', offers personal financial planning advice and counsel. Email firstname.lastname@example.org.