Quiz!
Which diversified investment looks more appealing?
- 15% average growth per year over the past 10 years, up from a long-term average of 10% per year.
- 5% average growth per year over the past 10 years, down from a long-term average of 10% per year.
Say that after 2 extra years, the faster growing investment continued performing better than 10% per year. Which would you choose now?
- The first one.
- The second one.
My Personal Experience with the Recency Bias
What is the Recency Bias? It is making decisions based on recent events, with the expectation that they will continue.
How can the Recency Bias hurt investors? Most investments are cyclical, while the recency bias assumes no cycles. Common harm is buying high after unusual gains or selling low after unusual declines. When done repeatedly, it can lead to long-term underperformance of a simple buy-and-hold strategy.
Are there less obvious cases of Recency Bias hurting investors? Yes. Many investors are disciplined enough to hold onto their investments at low points, but they may wait for gains before investing new money. Missing a 1% or 2% gain is nearly harmless. But some investors wait for more and more evidence. Once they see (and miss) 20% or 30% gains, some wait to buy at a dip, and some wait for more evidence of gains. Only after seeing 50% to 100% gains, some feel that the gains are here to stay, and invest after missing out on huge gains. The damage is far worse than simply missing gains, leading to a negative snowball. The delayed investment hurts their personal returns, they think that their investments are worse than reality, so they stay less committed to them, hurting their returns even further, cycle after cycle.
Did I ever experience the Recency Bias? Yes & no. When trying to think about the likely returns of an investment in the next 10 years, I know that it’s likely to be different than the past 10 years, given studies of investment cycles and valuation measures. But, in anomalous times, where a cycle gets stretched longer than usual, I am tempted to temper my expectations for the next leg of the cycle. I recognize that real life works the opposite – the longer we have an anomaly, the stronger the reversal tends to be. Examples of my recency bias:
- When looking at the raw data, it is rational to expect the S&P 500 to lose value over the next 10 years. But the recency bias leads me to believe it may get low positive returns.
- When looking at the raw data, it is rational to expect non-US Value (low Price/Book) stocks to enjoy unusually high returns over the next 10 years. But I catch myself sometimes expecting only average returns.
How damaging can the Recency Bias be? The examples I gave right above are not too harmful. They don’t lead me to make decisions that are opposite of rational, so I can live with them. The harm comes from an expectation opposite of rational, that leads to decisions that are very likely to fail. Here are examples:
- Expecting the S&P 500 to average more than 10% per year in the next 10 years, or even 6% or 8%.
- Expecting low interest rates in the next few years.
- Expecting AI-focused companies that reached extreme valuations to significantly outperform the rest of the market in the next 10 years.
How do I avoid big harm by the Recency Bias? I base my expectations based on a combination of:
- Full cycle, long-term behavior.
- Logic.
- Valuations (e.g. Price/Book) today relative to typical in the past.
Quiz Answer:
Which diversified investment looks more appealing?
- 15% average growth per year over the past 10 years, up from a long-term average of 10% per year.
- 5% average growth per year over the past 10 years, down from a long-term average of 10% per year. [The Correct Answer]
Explanation: High growth diversified investments tend to be cyclical, with reversals being more common than not after 10 years.
Say that after 2 extra years, the faster growing investment continued performing better than 10% per year. Which would you choose now?
- The first one.
- The second one. [The Correct Answer]
Explanation: When above/below trend continues beyond 10 years, reversals continue to be the more common case, with greater odds and magnitude.
Read this month’s article to find out what leads people to pick the other option for both questions.
Disclosures Including Backtested Performance Data