Don’t Let This Common Bias Hurt Your Investment Portfolio

In a previous column, I wrote about recency bias, which is the tendency to place too much weight on the latest performance trends while giving short shrift to other factors, such as fundamentals, valuation, or long-term market averages. I also raised the possibility that investors enamored of the market’s recent winners (namely large-cap growth stocks in the US) could be falling into this behavioral pitfall.

To some extent, a bias toward recency might be hard-wired into the human brain. Neuroscientists attribute this to limitations of short-term memory. The “little grey cells” involved in this type of memory have limited storage capacity and only retain information for shorter periods of time. And market news, by definition, focuses on recent events rather than long-term trends. As a result, recent events are top of mind, easier to remember, and often play an outsize role in investment decision-making.

But there are several steps investors can take to guard against these tendencies. Here, I’ll present a few ideas for how to do so.

5 Ways to Guard Against Recency Bias

1. Be a student of long-term market history. When I’m thinking about asset-class performance, I like to look at performance over as long a span as possible. The IA SBBI indexes are my go-to source for major asset-class statistics going back to 1926. The academic trio of Elroy Dimson, Paul Marsh, and Mike Staunton have compiled additional data going back to 1901 on about 20 different markets globally. For valuation statistics, Robert Shiller has published data on cyclically adjusted P/Es going back to 1871.

2. Remind yourself that market trends are cyclical. On a related note, it’s helpful to look at performance over rolling periods. For example, US stocks have pulled ahead of international stocks by a wide margin over most of the past 20 years, but non-US stocks dominated the global markets from 2002 through 2007. Similarly, while growth stocks have dominated over most of the period from 2008 through 2023, value stocks held up better during the low-return period from 2001 through 2008. The market’s inherent cyclicality means that prevailing market trends will eventually reverse, although it’s impossible to predict exactly when that might happen.

3. Think about performance in the context of macroeconomic regimes. For example, the Federal Reserve’s zero interest-rate policy prevailed over most of the period from 2009 through early 2022. During this period, repeated interest-rate cuts and successive rounds of quantitative easing set a nearly 15-year expectation of low borrowing costs. This policy created a tailwind for bond performance and helped drive the correlation between stocks and bonds into negative territory. Both of those factors made conditions ideal for bonds as portfolio diversifiers, but that regime came to an abrupt halt when surging inflation forced the Fed to make a series of rapid interest-rate hikes starting in March 2022.

4. Think about counterfactuals. One of Warren Buffett’s more famous quotes is, “You pay a very high price in the stock market for a cheery consensus.” In other words, if almost everyone seems to agree on a certain market outlook, it’s probably already built into market price tags. This implies two things. If the consensus turns out to be right, there’s less opportunity to profit from future returns, and if it’s wrong, there’s a greater potential for loss when prices eventually reset to reflect that reality. Whenever I hear market prognostications, I try to question them from a skeptical perspective. This means not just evaluating the evidence the proponents cite but also thinking about factors they might be overlooking.

5. Put your investment decisions on autopilot. This might be the most powerful tool of all because even if you’re inadvertently swayed by recency bias, it limits the amount of damage you can do to your portfolio. The best way to do this in practice is to set a long-term asset allocation and stick with it, rebalancing periodically to bring the asset-class weightings in line with target levels.

Investing a set amount of money with every paycheck—as many employees do when they contribute to a 401(k) or other workplace retirement account—helps build consistent savings habits that are less likely to be derailed by short-term market news. Having a written investment policy statement is another way to put mental guardrails around investment decisions. Your investment policy statement should include a target asset allocation, criteria for selecting portfolio holdings, and parameters for rebalancing.

Final Thoughts

Recency bias may be one of the most hazardous tendencies investors face. Investors who put too much weight on recent market results are often tempted to buy high and sell low rather than doing the opposite, or pile into hot market sectors at exactly the wrong time. But keeping the five precepts above in mind can help investors avoid these pitfalls.