The Economic Crisis And Recency Bias
By Pinyo • Oct 23rd, 2008With the current economic crisis in full swing, it’s easy for us to fall into the recency bias trap. In psychology, the recency effect is the tendency to remember more recent events or observations more vividly and give recent information more weight than historical information. Unfortunately, this recency bias could cause you to abandon your long-term strategy and hinder your ability to make rational investment decisions.
Recency bias in investing can manifest itself in many ways. For example:
- You decide to keep money at home instead of depositing it in the bank where you could earn up to 4% interest.
- You decide to move money into “safer” or “better” investments such as bonds and gold.
- You decide to cash out of your 401k because you couldn’t stand the 40% drop.
When you are making this type of decisions, you are letting recent events affect your long-term strategy to the point of abandoning what you once considered sound strategy. Sometimes, things will work out in your favor, but historically we know that it’s not wise to react in this manner.
Here are the likely outcomes:
- Your bank doesn’t fail and you missed out on 4% interest while keeping the money at home.
- The stock market begins to recover while bonds and gold begin to decline. You move money back in to the stock market and ended up chasing performance.
- You pay taxes and penalty on the early withdrawal. The stock markets recover and you miss out on the recovery.
Letting news and recent events drive your strategy is never a good thing. Instead, you should build a strategy that could weather both the ups and downs. This could be as simple as:
- Pick an appropriate asset allocation based on your time horizon and risk tolerance level
- Regularly add money to your investment portfolio
- Rebalance your portfolio annually
You may feel the urge to react to recent events and news, but history tells us that this is not the best course of action. As such, it’s best to find a strategy that works for you and stick to it.
All posts by Pinyo
Great post. We recently addressed the behavioral issue of “anchoring” on our blog, but the issue of “recency” is probably an even more powerful influencer in today’s environment.
In the end, it’s an investor’s behavior that will determine their investment outcome, and this includes the discipline to be patient in the most challenging of economic environments. Of course, this is easier said than done.
I’m going to keep plugging away with my retirement contributions. I think that my 30 year retirement horizon is long enough to make great strides based on the purchases I will make during this recession.
I am actually increasing my 401k and roth ira contributions. I am about 30 years away from retirement so I feel that I am getting everything at a bargain now, to make more money in the future.
Solid advice. And it’s not just recency bias that you have to worry about it is also about your tendency to extrapolate. Just because the stock market has been losing 5% a day for a week, doesn’t mean that this is a trend that will continue indefinitely.
Great advice, but what do you recommend for those of us who just started contributing to Roth IRA or 401k, since we are still in college and we really dont have any ‘history’ and all of u sudden our tiny savings are gone?
@Russ — I agree. With all the instant news and multiple media at our disposal today, it’s hard not to be influenced.
@Patrick — I am following the same course of action.
@Donny — Good for you. I wish I could do that but I am already maxing out both.
@Shadox — Good add on extrapolation. For long-term investors, I think it’s best to just ignore the daily noise and stick with a plan that works for you.
@G — That’s not what I mean by history. I was referring to historical performance of the stock market and how it recovered from prior corrections and bear markets. I think it’s great you are able to start while you’re in college. I think you should stick with your asset allocation and contribution plan and keep investing. Be thankful that’s it’s tiny savings that you are learning with and not hundreds of thousands.
In a business context this would be described as the “Opportunity Cost” of making one financial decision over another. For example withdrawing all your money from your bank and keeping under your bed, means that the opportunity to earn 4% interest is lost. It is only when you calculate the opportunity cost of choosing one decision over another that you can make a full assessment of the best financial decision to pursue