How Recency Bias Affects Your Portfolio Performance? How To Avoid Recency Bias?

Prakash Lohana, CFPCM, CPFA,
Ascent Financial Solutions Pvt.ltd

If I ask you to recall the names of 10 people you met this month, whom would you recall? Chances are you will recall the names of people whom you met most recently. This is called the recency effect. Similarly, if I ask you for an opinion about the behaviour or performance of your colleagues or employees, most of the time, their recent behaviour will influence your opinion. If one of your colleagues was very polite and humble since the beginning of your relationship but has not behaved well off late, your opinion might turn negative. So your recent experience affects your opinion the most and forms the recency bias. Events which occur recently have maximum impact on your mind.

Recency bias is one of the most common biases affecting our investment and other decisions in life. Here, events which have happened recently or information which we have received recently impacts our decisions to a greater extent.

When it comes to investing, people invest in an instrument which has recently done well. Particularly, you will see that in the stock market, maximum investment comes in when the markets are peaking.



The chart above gives data from October 1999 to March 2017. The red line shows Sensex levels, whereas the black line indicates gross mutual fund investments. The chart clearly shows that whenever markets are doing very well and going high, investments in equity funds sharply rise and vice versa. So, most of the times, people invest when the equity market is very high and stay away when the markets have fallen sharply. 

This behaviour is universal and the reason behind it is the recency effect. When markets go up and the returns of equity mutual funds are very good in the recent past, investors look at the recent past and start investing. Here, the subconscious mind starts believing that this behaviour of the markets will continue and they will make good returns, so investment at these levels increase. Similarly, when the markets fall and the recent past is not so good, people start believing that markets will fall further and therefore avoid investing more money in equity.

How the recency effect creates an illusion of safety and an illusion of risk?

Actually, the recency effect creates an illusion of safety and also an illusion of risk in the minds of investors.

Let me illustrate with a historical example.



In January 2008, when the Sensex touched the 21,000 level for the first time, it was an all-time high. In the preceding year (from Jan 2007 to Jan 2008), Sensex had moved up from the 14,000 level to 21,000 level, so it was a rise of around 50%. In this month (Jan 2008), equity mutual funds had the highest net 13,678 crore from the investors. Here, at this point, Rs. inflow of the Sensex had gone up by around 50% in one year, but the economy (corporate profitability) had not grown by even 20% and no economy can grow by 50% in one year, so at this point, markets were extremely overvalued and the risk-reward ratio was unfavourable. But due to the recency effect, investors started feeling very comfortable and forgot to consider the risk of the overvalued market.

On the contrary, they started believing that this will continue, so here there is an illusion of safety. There was no safety when Sensex was at 21,000 level, but there was an illusion of safety. This behaviour of investing more money at higher market levels created a bubble in the stock market and we all know what happened next. On the other side, when the markets started falling immediately after this and saw the bottom, Sensex level in March 2008 (when the Satyam fraud was exposed) of around 8,344, the net investment in equity mutual funds was around Rs. 544 crore only, which was not even 10% of what was recorded in January 2008. Here, the markets had fallen by around 61%, so ideally there was hardly any risk because economic activity in the country or corporate profitability had not fallen by even 5%, which shows that markets were undervalued and the risk-reward ratio was favourable. But unfortunately, those investors who were ready to buy equity at 21,000 Sensex level found equity markets costly at 8,300 Sensex level and were not ready to buy or hold. Isn't this a strange behaviour? Yes, but the reason is that at the Sensex level of 8,300, there was no risk actually, as whatever worst could have happened had already happened. But as the recent past was negative, there was an illusion of risk. There was no actual risk, but there was only the illusion of risk.

Both of these behaviours were irrational. Those who invested more money at 21,000 level in January 2008 had increased their average purchase price, as a result of which they could not make money for the next few years and saw negative returns in the next one year. Similarly, those who were not investing or redeeming their money from equity funds at 8,300 level in March 2009 could not gain out of the rising market in 2009-10 because the fall was an opportunity to reduce their average purchase price in equity, but they lost the opportunity. Ideally, they should have behaved exactly opposite to their actual behaviour. But the recency effect did not allow this.

Recency effect in real estate: The recency effect is not only seen in equity investing but also in the real estate market. From 2005 onwards, real estate prices in India, and in particular, Gujarat, started moving up. As a result, we saw that those who invested in properties between 2005 to 2007 got good returns by 2009. At this time, the equity market had fallen sharply, so at this point of time, real estate investment had given very good returns and equity investment had not given good returns in the recent past. As a result, investors started putting more and more money into the real estate market and this behaviour was again repeated, just as it happened in the stock market in 2007. By 2012, property prices went up sharply. Maximum investment happened in 2012, and since then, property prices in most of the regions have fallen or have remained stagnant for the last five years. Those who bought properties in 2005 had multiplied their money by four to five times by 2012. So, ideally, they should have sold their properties and booked profit, but they behaved exactly the opposite and bought more properties in 2011 and 2012. So, this increased their average purchase price, which caused the prices to go up to the level of the prices in 2011-12. Thereby, they lost the golden opportunity to book profits.

After demonetization, markets have gone up by around 15% to 20% in just 5 months and, as a result, in the recent past when the market is very positive once again investors are investing in equity. So be careful while taking your investment decisions and try to avoid impulsive investing.

To conclude, the recency bias is the most common and frequent bias affecting our investment decisions. So, to make rational decisions, we have to learn how to keep our decisions free from the recency effect. Following are a few suggestions which I recommend you adapt to keep yourself away from the recency bias.

Read History: It is said that history repeats itself. So keep tracking the history of the stock markets and investments. Every few years, market cycles are repeated and investors make the same type of mistakes. Every time when the market is high, the hopes are at peak and due to the recency effect, investors believe it will keep going high because this time it is different and markets will do very good. Sir John Templeton had said that "The four most dangerous words in investing are: 'this time it's different.'" My advice to you is whenever someone says 'this time it is different', please run away from there. Don't listen to him. Reading history will help you to think from another perspective and get away from the current market rises or falls and you will do things rationally.

Delay your decisions by 2 to 3 days: Whenever recency effect is at peak, you will feel tempted to take your investment decisions either buying at the peak of the market or selling at the bottom of the market after it falls sharply. Try to postpone your decision for three days. Let 72 hours pass and your emotions will calm down and you will be able to act rationally.

Adopt right portfolio management strategies: Your investment decisions (whether buying or selling) should not be based on the current market events or news. It should be based on long-term strategies like asset allocation and portfolio rebalancing. Those who don't adopt strategies are actually following tactical money managers.

Is this rational?: Whenever you find a situation where any asset class—whether it is equity or real estate—is performing on extreme sides (extremely good or extremely bad), before taking any buying or selling decisions, just ask yourself "Is this rational?" "Is the continuous rise in equity rational?" Meaning, is it supported by the rise in profitability? Or, when the market falls sharply, try to find if the profitability of the companies has also fallen to the same extent. This is the essence of logical thinking and one mantra that will lead you to rational and correct decisions.

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