May 30, 2013
Recency bias and reversion to the mean are very important terms to understand when it comes to investing. What do they mean and why should you care?
Recency bias and reversion to the mean are very important terms to understand when it comes to investing. What do they mean and why should you care?
Recency bias is where you focus on what just happened, whereas reversion to the mean is where you understand historical averages. Reversion to the mean tells us that the speculation that has driven up the price of a hot investment will bring the price back down to its historical mean some time in the future. It is important to understand recency bias and reversion to the mean, because otherwise you might get caught in a bubble. Therefore, you will waste a lot of money. As far as I know, people who invest money want to make money; not waste it. If they don’t understand recency bias or reversion to the mean, they are likely to accomplish the exact opposite of their goal.
That was an outstanding answer, Katherine! Let’s recap. Investors place way too much importance on what just happened (recency bias) and way too little importance on the historical averages of any particular asset (reversion to the mean). When investing, think long term and that usually means ignoring what just happened over the last month, year or decade. Just as Katherine stated, your pocketbook will be effected dramatically by understanding these two concepts.