What Is Recency Bias in Investing?

Recency bias is a cognitive error that happens when people assume a recent event has more weight than events further in the past. For example, you might assume that it will rain tomorrow because it has rained two days in a row. However, many factors influence weather patterns. Giving more recent data greater weight distorts accurate forecasting because it ignores those other factors.

It makes sense that humans become victims of recency bias. It’s normal for people to see unrelated patterns. From an evolutionary perspective, recency bias might have offered some advantages. If you’ve seen tigers in one area recently, it’s best to avoid that area regardless. It becomes a problem when applied to modern circumstances, though, because humans aren’t that good at weighing the pros and cons of abstract concepts, like the value of a company.

Recency bias in investing happens when people apply this cognitive error to their investment choices. For instance, you might choose to buy a stock because you see its price soaring after an earnings report. The elevated valuation of the stock, however, may be overblown relative to the fundamentals. Eventually — within a few days, weeks, or months — the market could make a correction that brings share prices much lower and in line with the company’s true value.

Examples of Recency Bias

You probably see examples of recency bias in your life pretty often. For instance, when a basketball player hits two three-pointer shots in a row, you might assume they’re on a “hot streak.” If you believe the hot streak will influence the rest of the game, you might place a bet that the player will make the next three-pointer successfully or that the team will win.

It’s possible that the player might sink the next shot, but it probably doesn’t have anything to do with a hot streak. When you review the game later, you see that the player missed several shots before and after these three. It may have been more of a coincidence that three shots in a row were successful among a random selection of throws.

What’s Wrong With Recency Bias in Investing?

Recency bias in investing can put your investment dollars in jeopardy by convincing you to buy over-valued assets or sell under-valued assets.

Over-Valuing a Stock

Recency bias can convince investors that a stock is more valuable than it really is. For example, an influential investor with a television show might tell viewers that he expects a stock to soar soon. When people think about buying, they give more weight to the celebrity’s claim than they do historical information. The historical information isn’t worth less than the recent claim, but people give more credence to the new information. They might then purchase shares and be disappointed when a slight bump in value falls a few days later.

When overvaluations become large enough, they can create economic bubbles. With an economic bubble, the perceived value of a company or sector grows far beyond its real value. The dot-com bubble is one of the largest bubbles in recent history. During the 1990s, investors and venture capitalists became so excited about the rapid growth of internet technology that they poured unprecedented amounts of money into the sector.

Eventually, the market made a correction and the bubble burst as more prudent investors pulled their money from companies. The Nasdaq index lost 76.81% of its value. It took 15 years for the index to recover its losses.

Under-Valuing a Stock

Companies with strong foundations and plenty of growth opportunities can have lackluster quarters that make them look less valuable to short-term investors. When that happens, some investors will sell off their shares and drive the price down.

Following a sell-off trend might be a mistake that prevents investors from reaching long-term financial goals. Instead of trusting in a company that has performed well for years, you follow a fad that doesn’t consider the bigger context.

Selling shares isn’t always a bad idea, obviously. What matters is the reason you decide to sell.

How to Protect Yourself From Recency Bias

Taking a planned approach to investing is one of the best ways to protect your portfolio from recency bias. Treat your portfolio the way successful investors like Warren Buffett treat theirs. You’ll notice that Buffett tends to purchase shares in companies that have high potential for success. He then holds the shares and waits for them to become more valuable as the company grows.

Of course, you probably don’t have Buffett’s billions or a team of professionals researching investment opportunities. Maybe it isn’t fair to expect the typical investor to behave like him. That doesn’t mean you can’t use a strategy that minimizes the influence of recency bias in investing.

Don’t Make Sudden Decisions

Smart investing requires research and deliberation. Very few people build wealth from speculative, short-term trading. If you feel pressured to make a decision immediately, take that as a sign that you should give yourself more time to take a close look at the stock.

In some cases, you might decide that you don’t want to keep investing in a company. Most of the time, however, you’ll see that your earlier research pointed you in the right direction.

Schedule When to Review Your Portfolio

The more often you review your investment portfolio, the more likely it is that you will become a victim of recency bias. Imagine someone who looks at their investments every day. That person creates daily opportunities for recency bias to influence their decisions.

Most investors don’t need to review their portfolios daily or weekly. Depending on your strategy, you might want to check its performance once a month or once a quarter.

Remember that your goal is to build a portfolio that meets long-term investment goals. When you focus on those goals and let your investments work for you, you don’t need to tinker with your portfolio very often. If you already have a solid plan, you might only make significant changes once a year.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.