Investing
How does recency bias affect the average investor in a very negative way? Once understood, how can the average investor overcome this problem not only with their investments, but with their life?
How does recency bias affect the average investor in a very negative way? Once understood, how can the average investor overcome this problem not only with their investments, but with their life?
Recency bias affects the investor as they become overly influenced by what has just occurred. Recent events cause us to think what just happened will continue to happen.
Here is an example: The market has dropped 10% over the last month. Our mind thinks the market is tanking (pundits on television and the internet feed this fear) and will continue to go down so we freak out and sell. Low and behold reversion to the mean occurs (markets will revert back to their historical averages over time, we just don’t know when). You screwed up!
The opposite can happen as well. The market goes up 10% over the previous month and you decide to put more money in (this is called chasing performance and it is a really bad idea) thinking the market will continue to go up, up and up. Well, reversion to the mean occurs again and now you have whiplash on the other side of the trade.
So what is a person to do? First, educate yourself on the issue so you clearly understand how you are affected by recent events (a recent event can be the last year so don’t think it applies to only a few days or weeks). This would also drive you to understand reversion to the mean.
Understanding them both will reduce the whiplash of making bad emotional decisions with your investments AND your life. Stay rational in a very irrational world. Financial freedom may just start appearing in your life!