The Economic Crisis And Recency Bias
, on October 23, 2008
With 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.
If you like this article, please sign up for our free weekly updates
The information on this site is strictly the author's opinion. It does NOT constitute financial, legal, or other advice of any kind. You should consult with a certified adviser for advice to your specific circumstances.
While we try to ensure that the information on this site is accurate at the time of publication, information about third party products and services do change without notice. Please visit the official site for up-to-date information.