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Recency bias: why investors must be aware

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Stock markets go through cycles of up and downturns, but tend to level out over time. That’s why investors who react to short-term changes can lose out. Data shows that staying invested pays off in the long haul.

It’s hard to keep calm and carry on when stock markets fall and you see gloomy headlines about the economy. But that’s exactly why it’s important to fight the urge to do something.

Swings in the stock market don’t often last long, and aren’t a reliable indicator of how the market will perform next year – or even next week. Getting out now might be bad for the health of your investments.

Of course, that’s easier said than done. During a bull market, when share prices are rising, we tend to forget about the bad times and assume things will keep getting better. And during a bear market, when share prices are falling, we think that the market will never rise again.

There’s a name for this kind of behaviour – recency bias It makes investors take too much or too little risk because they are focused on recent events at the expense of longer-term trends.

This can result in missing out on share price gains, good deals on under-priced assets, or even a diversified portfolio.

Recency bias in action

The financial crisis in 2008 is a good example. Many investors sold because they were panicking about their losses and fearing the worst was yet to come. That pretty much locked in their losses.

They thought they were protecting themselves from further damage. Many took the view that they could buy investments back for less once things calmed down.

However, the memory of their loss lasted longer than the stock market fall. And when prices bounced back, these investors had not only locked in losses, but also missed out on a chance to recover.

Why you shouldn’t get too comfortable

It’s almost impossible to predict movements in the market. Even experts don’t know when prices have hit rock bottom. And stocks can be very volatile whether the market is rising or falling. For example – the FTSE All-Share Index recorded eight of its strongest days during the 2008 crisis.

Recency bias isn’t just a problem when stock markets are falling. When share prices are going up, it can be easy to assume that will go on forever. That’s what happened during the dot-com bubble burst of 2000, when many investors assumed the stock prices would keep on rising.

During a bull market, investors are often tempted to keep buying stocks. That means more risk in their portfolio, and a failure to diversify across different asset classes. When a bear market hits, they’re left unprotected.

Thinking long term

If you focus on what’s going to happen in the long term, you can avoid the temptation of reacting to recent events.

Your portfolio should reflect your approach to risk and financial goals, not what’s happening in the stock market right now. If some investments increase or decrease in value, it might mean you have to rebalance your portfolio and reallocate how your assets are split.

You can do this by taking profits from your top performers and reinvesting the proceeds into the weaker ones. To learn more about how you can build a well-balanced investment portfolio, read our guide to blending assets.

Sticking to your plan also helps ensure your portfolio stays diversified. By spreading your money across a variety of investments, including shares, bonds and cash, you’ll be less exposed to downturns in the stock market.

You could also think about investing across different sectors. Manufacturing, for instance, is one of the UK’s largest sectors, but during the five years following the financial crisis (2007-2011), the industry entered recession three times.

Preparing for retirement

Recency bias is particularly dangerous if you’re closer to retirement. As an example, if you take on more risk when the stock prices are rising and there’s suddenly a crash, your investments could suffer a huge fall right around the time you’re retiring.

A big drop in the value of your retirement funds prior to, or soon after, retiring can dramatically reduce the chances of your savings lasting your lifetime.

So, whatever your investment journey, keep a cool head and keep an eye on your long-term goals. That way, you can avoid making quick decisions you regret later.