Recency bias and its impact on investments

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New Delhi: If someone were to ask you how your day was at the end of the day, you’ll most likely give them an answer based on the most recent thing that happened to you before you were asked the question. Or, while discussing a cricketer’s performance, people often tend to gauge his/her performance based on their recent form, and not their career-long statistics. This is called recency bias.

What exactly is recency bias?

Recency bias is a psychological phenomenon where we tend to give more importance to recent events as compared to ones that happened a while ago. It is an interesting occurrence from a behavioural economics point of view. Just like this bias is observed in daily life, recency bias is also pervasive in investing. Investors tend to give more importance to the short-term performance of a stock or a fund rather than taking into account its past performance. For instance, if an investor has invested Rs 1,00,000 in a company’s stock over time, and after five years his return is Rs. 2,00,000, but in the last 2 months his return falls to Rs 1,70,000. Then he will look at his investment’s performance as a loss of Rs 30,000 in two months, and not a gain of Rs 1,00,000 over five years.

Why is recency bias harmful?

Recency bias often clouds an investor’s judgement and is detrimental to his/her financial well-being in the long term. Due to this bias, an investor may choose to stay away from a certain company’s share, when in fact they should be thinking the other way round and taking advantage of the dip in its price, provided the company has performed well in the past and is only going through a brief bad spell.

How to avoid recency bias?

An understanding of market movement is important to avoid recency bias. One must know that the markets work in cycles and a bear cycle is usually followed by a strong bull cycle. Investors must also keep in mind the bigger picture, and their portfolio and not get too worried about short-term losses. Dropping good stocks because of their recent performance may not be a good idea if the company is fundamentally sound. During turbulent market times, it is always a good idea to consult a financial advisor to help you navigate the reds and minimize losses.

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