Behavioral Finance: The Far-Reaching Risks of Recency as published in InsideNova.com
A few articles ago, I introduced the field of behavioral finance, and the threats investors face if they ignore the emotional, instinct-driven side of money management. I promised to follow up with some of the specific biases that impact otherwise rational investors … like recency. It’s a good one to recognize if you’re wondering what to make of recent increases in market volatility.
What is recency? Recency causes you to pay more attention to your most recent experiences, and to downplay the significance of long-term conditions. For example, in their book “Nudge,” Nobel laureate Richard Thaler and Cass Sunstein observe: “If floods have not occurred in the immediate past, people who live on floodplains are far less likely to purchase insurance.” That’s recency, tricking people into ascribing more importance to the lack of recent flooding than to the bigger context of being located on a flood plain.
When is it helpful? In “Stumbling on Happiness,” Daniel Gilbert describes how we humans employ recency to accurately interpret otherwise ambiguous situations. Say, for example, it has rained the last 5 days in a row. Recency may convince you to grab the umbrella on your way out the door, even if you haven’t had time to check the weather reports.
When is it harmful? Buying high and selling low is exactly the opposite of investors’ actual aspirations. And yet, no matter how many times our capital markets have moved through their bear-and-bull cycles, recency causes droves of investors to stumble. By reacting to the most recent jolts instead of taking a step back and remembering long-term trends, you end up piling into high-priced hot holdings during market run-ups and locking in losses by selling low during the downturns. That’s recency, getting the better of you.
How to overcome? Instead of reacting to recent market movements, take control by acting in adherence to the personalized investment plans you crafted for the long haul. Avoid fixating on daily news and current events, at least with respect to your investing.