Thursday, March 22, 2012

Is ‘recency bias’ clouding your long-term view of the stock market?

What is ‘recency bias’ and why should it cloud any one’s long-term view of the stock market? As human beings, we tend to be more emotional than rational – specially when it involves investing in stocks or mutual funds. The two emotional extremes of greed and fear has dominated investment behaviour through the ages – from the boom and bust of ‘tulipmania’ in 17th century Holland to the ‘ mania’ in the USA in 1999-2000 and the ‘real estate mania’ in the USA and India 5 years ago.

‘Tulipmania’ happened too long ago. ‘ mania’ is almost a forgotten story. Its effects were restricted to the technology sector anyway. But effects of the ‘sub-prime’ crisis in the USA and the ‘land bank’ story in India are still remembered and felt by investors. This is how ‘recency bias’ takes hold of our psyche. We tend to remember what has happened more recently and get biased about what is likely to happen in the future.

It requires a lot of mental discipline and experience to take a dispassionate view of the market. Overcoming greed and fear is a difficult proposition when your hard-earned money is at stake. Being able to decide against the current market fads and themes requires strong nerves and conviction. But even experienced investors some times allow their long-term view of the market to get clouded by ‘recency bias’.

For instance, the recent bear period from Nov ‘10 to Dec ‘11 caused many seasoned and new investors to take extremely bearish views of the market. ‘Filling the gap’ formed in the Sensex chart in May ‘09 (after the Lok Sabha election) and a further fall to test the Mar ‘09 low were discussed on TV channels and investment groups. Questions were raised whether the Sensex was in a secular bear market that started in Jan ‘08 and whether the enter rally from Mar ‘09 to Nov ‘10 was a bear market rally. Memories of the massive crash in 2008 were obviously fresh in investor minds.

More recently, the rally from the Dec ‘11 low to the Feb ‘12 high prompted many experts to talk about a possible test of the Nov ‘10 peaks on the Sensex and Nifty. One report from an overseas brokerage gave detailed technical explanations of why the Nifty will touch 10000. But when the index reacted from 5600, there were opinions galore about a fall to 4800 or even a test of the previous low of 4500. And so it goes on.

‘Recency bias’ can be good or bad for your portfolio’s health. It can be bad if you are not aware that you may have such a mental bias. If you are sitting on a lot of cash because you wanted to invest if the Nifty fell below 4000 and failed to invest at 4500, then your returns on that cash has been negligible. If you are still waiting to invest because you think the Nifty may fall below 5000, your are allowing your long-term view to be clouded by ‘recency bias’.

‘Recency bias’ can be good if you are aware of it and take suitable investment decisions. For instance, high inflation rate led to increased interest rate. If you do not project higher interest rate into the future, and invest a portion of your cash in a bank fixed deposit or tax free bonds to avail of the current high rates, it can provide stability to your investment portfolio. If you slowly accumulate fundamentally strong stocks trading near their 52 week lows, then you are not allowing ‘recency bias’ to cloud your long-term view of the stock market.

How do you separate emotion and ‘recency bias’ from your investment decisions? One way is to regularly invest your monthly savings without paying too much attention to index levels. Another way is to make an asset allocation plan as per your risk tolerance and financial goals, and let the plan provide the signals for buying and selling.

Related Posts

How to reallocate your assets
Some practical examples of Behavioural Finance


scorpio said...

nice post as usual :) its good you put up the earlier links, I had missed reading one of them.

Subhankar said...

Appreciate your comments, Ashish.