Investors suffer from recency bias
Written by Ang Kok Heng
Monday, 02 November 2009 10:36
Human beings suffer from various forms of psychological biases (see Table 1). One of them is recency bias. Recency bias is a kind of mental myopia where investors focus on the more recent events, that is giving more weight to the recent happenings. Like many other diseases where there is no known cure, there is also no known financial doctor who can heal this mental myopia as it is hereditary.
Everyone, irrespective of race or level of education achieved, suffers from this problem, the only difference is the degree. In the absence of a cure, the only advice is for one to understand the cause of the disease, and learn how to control it so that we can reduce incidents of bad decision, while at the same time make more sensible investment decisions.
Short memory
As humans tend to have short memories, events that happened months or years ago tend to be neglected. Instead, recent incidents that are of lesser importance are still fresh in the memory. These incidents have a strong impact on our day-to-day judgement as they interfere in the decision-making process and influence our decision on a particular assessment.
Unlike the memory of a computer where every file is kept according to the names, the human mind arranges the “files” according to time and relative importance. Recent affairs are fresh in the memory. Some of the more important events are also kept at the top of our mind, but trivial events are suppressed to the bottom so as to release more room for the brain to remember relatively more important happenings (see Chart 1).
Some of the very important occurrences that happened recently will always be at the top of our mind. As a result, our brain will always remind us of other recent events, especially those which are more important. From time to time, our brain will also recall some of the more important happenings that occurred many years ago. There is also a tendency for old information to be out-weighed by new information, even though both are of equal importance.
All these “reminders” that pop up during our decision-making process influence our judgement sub-consciously.
Narrow framing
Another problem of recency bias is short-term bias. Many people are focused on the immediate future and are not too interested in the broader perspective. This phenomenon is sometimes called “narrow framing”, as it distorts our perception to the point that we do not think rationally. It changes the way we think, the way we analyse an issue. This framing bias gives a selective simplistic picture of reality.
Narrow framing is seen in emphasis by analysts to focus on quarterly results. A company which performs poorly in the latest quarter tends to be downgraded by analysts as if the poor showing is sure to be continued over the next few quarters. A more detailed analysis is needed to determine whether a particular below-average result is due to a luck factor, events beyond the control of the management, cyclical nature, change in circumstances, etc.
Unfortunately, most analysts and fund managers place undue emphasis on the belief that what has just happened to a company will continue to happen. As analysing quarterly results is the job of analysts, they tend to be over-excited by short-term changes of earnings, and they have the tendency to exaggerate transient changes.
There is no denying that the poor results of some companies signal the beginning of their downturn. Unless there is clear evidence to show that a drastic fundamental change has occurred, it would be too simplistic to assume that every company having a weaker quarterly profit will continue to go down.
Emphasis on recent trends
A study by Kahneman and Tversky in 1973 found that people usually assume there is a strong correlation between the recent past and future outcomes.
Investors believe recent trends can predict future market directions. Assume the market goes up five times and down five times. The different orders of the up-market (U) and down-market (D) will influence investors’ perception differently. If the market is directionless (as in Chart 2a), investors will not be able to decide where the market is heading. But if the market forms an obvious downtrend recently (Chart 2b), fear of a further downturn will make investors bearish for the immediate outlook. However, if the market has been trending upwards recently (Chart 2c), there is a tendency that investors will believe the market will continue to go up.
In all three examples, the market comes back to the original level. Investor (a) is at a loss. Investor (b) feels like selling to preserve the capital after the initial market run-up. Investor (c) is hopeful that the market is recovering again after the initial losses.
This type of psychology is also seen in punters who play roulette in a casino on the belief that recent results will form a pattern. In fact, each outcome is independent of previous outcomes. Similarly, a series of heads from tossing a coin will not show nor give you the ability to predict the exact outcome of the next toss, whether it is a head or a tail.
In predicting the outcome of market direction the next day, the past few days’ performance will not be sufficient to predict the market direction correctly. If there is any correlation, the degree of accuracy using the past few days’ performance to predict the next few days’ direction is only marginally relevant.
More weight on recent events
Given a list of items, most people tend to recall the items at the end of a list rather than items in the middle. This type of human weakness in recency bias is exploited in many instances.
For example, lawyers schedule the more “influential” witness at the end of the witness appearance in court to influence the judge or jury; event managers schedule a list of speakers to achieve the desired results at the beginning or end of an event; personnel managers emphasise the recent conduct of an employee to judge the performance of the employee, etc.
There is a tendency for an investor to focus on “what happened lately” while making a decision. This recency bias puts more weight on recent events rather than looking at the longer period of evaluation. An investment for a longer period of three to five years should not be evaluated based solely on the past six months’ events and ignore the happenings of the past few years.
Reinforced by frequency
Recent happenings can also be reinforced by the frequency of news heard or read. Investors are biased by the frequency of news received. A piece of news repeated many times is lodged more deeply in the mind than one that is broadcast only once. The more times an investor hears or reads about a particular piece of news, the more likely he or she will react to the outcome of the news. This is because repetition distorts our belief that a particular event is more important.
Unfortunately, the media likes to repeat and sensationalise a particular type of news, especially negative ones. This type of biased reporting will only mislead investors into making prejudiced decisions. In the recent crisis, the negative comments and fear of recurrence of a 1930s-style depression were repeatedly broadcast by both the electronic and print media, and it swayed many into believing that another depression was imminent.
Other than distortion by frequency of news, breaking news that highlights a particular incident — usually negative — will also increase the bearish opinion of investors as if such a mishap would happen again soon. Getting influenced by such reporting does not help investors in rational thinking.
Recency leads to overconfidence
A series of recent successes may also lead to overconfidence in investors, as if nothing could possibly go wrong. The years upon years of success of LTCM (Long Term Capital Management) in managing a client’s money misled fund managers into believing that their strategies were perfect. In order to make more money, they increased their leverage and bet heavily on Russian bonds. The unexpected collapse of the Russian economy resulted in huge losses that led to the subsequent downfall of the invincible LTCM in 1998.
The Internet stock rally of the early 2000s is also a good example of how the daily gains in the “new economy” dot.com stocks misled investors into believing that the momentum would continue, and that these hot stocks will just keep rallying.
We all fall prey to recency bias, whether you are a professional fund manager or an individual retail investor. There is a strong tendency to believe in our hearts that whatever happens recently is going to continue. As such, a bull market enhances market confidence, and a bear market depresses the mood of investors. Unknown to many, the changes in our emotions are dictating our actions, which rationally should be determined by the real fundamentals.
Distancing from recent losers
The recent global financial crisis resulted in losses in almost every asset class, and many investors cut their losses and regretted having invested in those assets. Losses were seen in every bourse. Institutions and high net-worth individuals redeemed their investments from hedge funds.
Unit trust investors avoided high-risk equity funds and opted for guaranteed structured products. Bond investors also saw losses due to a perceived increase in credit risk. Bond investors avoided lower grade bonds in favour of AAA and government bonds. Even low-risk money market funds were faced with massive redemptions early this year, as investors were fearful of possible bank failures. All these have passed ,and investors now are more rational as the economy is obviously recovering gradually.
Following recent performers
The exit from market losers benefited the strong performing asset classes — one of which is gold, which has performed well after the financial crisis. It is common for investors to avoid recent, poorer-performing investments and chase after stronger performers. Investors believe that those investments which have performed well recently will continue to do well.
This recency bias influenced many unit trust investors to put in more investment during the bull market when funds were showing strong gains. Similarly, during the bear market, unit trust investors were avoiding this investment for fear of further losses. Instead of buying low and selling high, unfortunately, unit trust investors always fall prey to recency bias and perform the opposite. Similar mistakes were also made in other forms of investment where investors chase after strong performers.
Unknowingly, the psychological weakness of investors cause many investors to adopt the wrong investment approach. What investors need to do is diagnose the degree of recency bias they suffered, and how to control such deficiency.
Ang has 20 years’ experience in research and investment. He is currently the chief investment officer of Phillip Capital Management Sdn Bhd.
This article appeared in The Edge Financial Daily, November 2, 2009.
http://www.theedgemalaysia.com/business-news/152639-investors-suffer-from-recency-bias.html
