Recency bias

Whatever happened most recently feels like the way things are. After two good years in equities, it seems obvious that equities will keep rising; after a crash, it seems obvious they will keep falling. That is recency bias: the impact of recent events on decision-making is very strong, and the investor extrapolates the event into the future and expects a repeat.

The workbook is careful to say the bias cuts both ways. It applies equally to positive and negative experiences:

• A bull market makes people allocate more to risky assets than what is advised. A rise in equity prices makes people think only of a further rise, so more money goes into equities and the risk goes up.
• A bear market or financial crisis makes people prefer safe assets. A fall in an asset makes people stay away, expecting it to fall further — and that can mean missed opportunities.

In both cases, as the workbook puts it, the recent experience overrides analysis in decision making.

Recency bias does its damage by quietly overriding the investor's strategic asset allocation. The target was set from goals, time horizon and risk profile. Recency bias replaces that target with a reaction to the last few months.

Notice that the plan's answer in each row is rebalancing, which the workbook describes as making the investor buy low and sell high without taking a view on markets. Recency bias pushes in exactly the opposite direction.

The bias also corrupts risk profiling. An investor's self-reported willingness to take risk rises after a bull run and collapses after a crash, so a profile taken at either extreme is unreliable. The workbook's general prescription for biases applies: detailed analysis rather than shortcuts, and the opinion of a third person — a Registered Investment Adviser or a Mutual Fund Distributor — to detach emotion from the decision.

Vikram's plan is 60:40 equity to debt on a portfolio of Rs 10 lakh. After a year in which equity funds rose sharply, he is convinced the rally will continue and shifts to 85:15. The next year equity falls 20 per cent and debt earns 7 per cent. Figures are illustrative.

The tilt cost him Rs 67,500 more than the plan.

Now the second half of the bias kicks in. Having lost money, Vikram decides equities are finished and moves everything to debt at the bottom. If equity then recovers 25 per cent, the Rs 6.80 lakh he pulled out would have become Rs 8.50 lakh — a recovery of Rs 1.70 lakh that he no longer owns.

The same Rs 10 lakh, left at 60:40 and rebalanced, would have bought equity after the fall instead of selling it.

Chapter 1 (Investment Landscape), section 1.6, describes recency bias with the bull-market and bear-market examples; sections 1.7 and 1.8 supply the risk profiling and asset allocation it disrupts. Expect a scenario question — an investor piling into equities after a rally, or refusing to invest after a crash — asking which bias is at work, and a question on the workbook's remedy.

• Recency bias works in both directions. The workbook says it applies equally to positive and negative experiences; an option limiting it to panic selling is incomplete.
• Its signature is extrapolation — expecting the recent event to repeat. Following other people is herd mentality, a different bias.
• Preferring what you know is familiarity bias; seeking information that confirms your view is confirmation bias. Keep the labels separate.
• In a bull market it increases risk by pushing allocation to risky assets above what is advised.
• In a bear market it causes lost opportunities by keeping investors away from assets that have fallen.
• The antidote in the workbook is analysis over shortcuts and the opinion of an RIA or MFD — and, in practice, sticking to the strategic allocation through rebalancing.