How Recency Bias Affects Investment Decisions
When we don’t have enough information, or conversely feel overwhelmed with the information that’s available, we use mental shortcuts to make decisions. The term for this is cognitive bias.
This happens all the time in investing, no matter how much we’d like to believe that our investment decisions are perfectly logical and rational.
Recency bias is just one type of cognitive bias that can affect investment decisions. This is when greater importance is given to the most recent event or newest information and is common and costly for investors.
Take for instance, the investment returns of North American equity indices over the past two decades.
In the first chart, we see that from 2000-2009, the US S&P 500 index (represented by the SPY ETF) had a cumulative -9%+ return, while MSCI Canada (represented by EWC ETF) had an overall +136.2% return.
By the end of that decade, Canada was where all investors wanted to be.
This caused many investors to miss out on much of the next decade’s returns from US stocks.
By 2021, investors became eager to allocate money to large US tech stocks and it was hard convincing some to allocate to value and energy stocks.
So far in the 2020’s there is no clear winner yet as of April 2022.
Zooming Out to See A Fuller Picture: The first twenty years of the century (2000-2020) & the most recent twenty years (2002-2022)
If we shift the starting period just two years later, to 2002, after the “tech wreck”, the annualized rate of return jumps up to approximately 9%, up from approximately 6.5%.
This just goes to show how easy it can be to get different information from very similar data.
How Diversification Can Minimize Loss From Recency Bias
As we zoom out to view the last century, 2000 until present date, you can see both markets ending up in a similar spot (below). The purple line in all the charts is a simple 50% combination of both markets represented by two investable ETFs SPY and EWC.
This isn’t meant to be a recommendation to invest in this 50/50 split. The point is to illustrate how diversifying over the long run can give a slight edge over BOTH markets and provides a smoother ride and better investment experience, which will make it easier for investors to stay the course and capture long-term returns.
Disciplined diversification also guards against the dangers of recency bias, the impulse to overweight asset classes that have worked well recently.
Nobody knows what markets will do one day, week, or month from now.
By diversifying you increase the chance of being broadly correct rather than precisely wrong.
In a future post, I will elaborate on how further diversification such as adding equities with certain characteristics (such as overweighting small cap value stocks, seen in purple in the chart below) builds on what has already been discussed above.
Closing Thought
Don’t look at a stock or ETF as a ticker symbol with a price that moves up and down on a screen. It’s a share of a companie(s) profits far into the future. That’s how you ought to evaluate it.
“When we buy a stock, we would be happy with that stock if they told us the market was going to close for a couple years. We look to the business.”
– Charlie Munger
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