The U.S. stock market has been on a tear. Since the beginning of 2013, the S&P 500 has risen over 31% in value (through March 31, 2014). Over the last five years, the S&P 500 has risen over 135%! These have been outstanding returns, and for many investors, they have a nagging feeling of missing out. If you have been thinking about how well the markets have done recently, and are considering making a major change in your investment strategy, it may be time to take a closer look at recency bias, and how it can impact the human psyche, especially when it comes to investing.
I read an article recently by Carl Richards in the New York Times that addressed recency bias. He does a great job of breaking down complex ideas into simple drawings that get the point across. He used an example about a shortage of road salt resulting from the tough winter experienced in Long Island, NY and how the transportation department could respond if they suddenly think every winter will be as harsh as the last one.
Recency bias is the tendency of people to put too much importance or weight on experiences they’ve had in the recent past. We tend to think that what has happened recently will most likely continue indefinitely into the future.
Individual investors are notorious for being susceptible to recency bias. They tend to follow hot trends, and pile money into asset classes where prices have risen dramatically, and are often disappointed when the assets drop in value and come back to earth. Given the recent run in U.S. stocks (represented by the S&P 500 returns above), I’ve been asked by many people whether they should invest more aggressively to take advantage of these returns. This is a perfect example of recent experiences driving decision-making.
The decision to adjust one’s portfolio asset allocation should be driven by their goals, objectives, risk tolerance, and investing horizon. For some folks, it might make sense to adjust their portfolio allocation to get it more in line with their financial plan. However, the recent stock market returns should not be the primary driver of this decision. If it is, it may lead to taking on more market risk than acceptable, and disappointment the next time stocks fall out of favor and the market goes down.
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