How To Avoid Recency Bias Trading And Investing In Stocks

by: Macro Ops
Summary

Recency bias is believing what occurred in the recent past will continue to occur in the future.

Investors consistently fall victim to this bias. It's the main contributor to the complacency we see during each market cycle.

Strategies tend to work for a period of time until they don't. And, it's usually the previously successful strategies that end up failing the hardest in the new environment.

Recency bias is believing what occurred in the recent past will continue to occur in the future.

Say you flip a coin and get heads five times in a row. Naturally, you'll begin to think the sixth flip will also be heads. Heads is the trend. But, in reality, you'd be wrong. This is called recency bias. You're letting recent outcomes incorrectly influence your belief of future outcomes. No matter the outcome of the previous trials, the probability of the next coin flip being heads will always be 50%. Believing anything else is illogical.

Investors consistently fall victim to this bias. It's the main contributor to the complacency we see during each market cycle. Consider the "buy the dip" mentality that plagued the post-QE era. One of the greatest financial crises in history occurred 8 years prior, and in the time in between, investors trained themselves to throw risk management out the window and aggressively buy more each time the market fell.

It's true that "buy the dip" worked well during that time, but there was no guarantee it would work in perpetuity. This is especially true considering the nature of market cycles. Strategies tend to work for a period of time until they don't. And, it's usually the previously successful strategies that end up failing the hardest in the new environment.

No one wants to be caught buying the dip when the market morphs from bull to bear. But, unfortunately, recency bias leads a majority of investors straight off that cliff. "Buy the dip worked before… so it must work again!" Nope. Sorry.

As always, stay Fallible out there, investors!

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.