Cognitive biases can affect any investor, whether you’ve been investing for decades or are brand-new to the markets. But the influence of these biases on your investment decisions can be detrimental to the growth of your portfolio, so it’s important to understand how they work and how to avoid them.
One of the most common biases among retail investors, according to the BeFi Barometer 2021 study, is “recency bias”. Read on to learn more about what recency bias is and discover four ways to avoid it affecting your wealth accumulation.
Recency bias makes you think recent events are more likely to reoccur than is statistically likely
A common analogy used to explain recency bias is the film Jaws. Did you avoid swimming in the ocean for a little while after you watched it? Even though you probably already knew that the chances of being attacked by a shark are extremely low, seeing the film may still have made you a little afraid of getting in the water.
It’s the same with investing. If something significant causes a shift in the markets – such as the recent collapses of Silicon Valley Bank and Credit Suisse – it can make you feel nervous about your portfolio. Maybe you feel so worried that you decide to move your money out of your carefully chosen portfolio because you think a similar event might happen very soon.
The opposite, of course, can also be true. A new trend or sudden surge in value of a particular stock might tempt you to move some money into it to benefit from the growth.
When these sorts of things happen, your emotions can take over and you forget or ignore the likelihood of the event happening again any time soon. This can cause you to make decisions that aren’t entirely logical and that could even be detrimental to your investment returns over the long term.
Acting on recency bias can cause your portfolio to grow more slowly than it might have done otherwise
When significant events influence you to change your investing behaviours out of fear or panic, you’re acting on short-term decisions rather than long-term thinking. Doing so means acting against one of the fundamental principles of investing success: that your investments should always be made with consideration to their long-term potential to help you achieve your goals.
An example shared by Schwab Asset Management looks at the performance of financial services stocks in the S&P 500.
In 2019, the best-performing sector in the S&P 500 was financial services, returning an annual increase of 32%. Many investors might have been tempted to invest in stocks in this sector as a result, perhaps expecting that growth to continue indefinitely. However, if you’d done this, you would have made a loss in 2020, when the sector dropped by almost 2%, when the S&P 500 Index returned more than 18%.
This example shows how past performance is no guarantee of future returns, and as such, serves as a cautionary tale against making investment decisions based solely on recent or current events that may not persist.
4 strategies to avoid recency bias affecting your investment decisions
You’re only human, so recency bias and other emotional reactions to significant events are hard to avoid when investing. That said, there are a few ways you can reduce the likelihood of recency bias affecting your investment decisions.
1. Limit your exposure to financial and stock market news
Media headlines are designed to capture your attention, and that usually means focusing on the negatives. It’s easy to see how even small market shifts could cause panic when they’re reported in this way.
A simple way to stop yourself from getting caught up in the frenzy is to limit the amount of time you spend reading news updates. While it’s good to stay abreast of important developments, checking in on the headlines daily isn’t necessary.
2. Remember the key principles of investing
Even though past performance does not guarantee future returns, understanding the history of the stock market and the fundamental principles of investing can be extremely helpful. Concepts such as the importance of diversification, the correlation between risk and reward, and investing for the long term have served investors well for the past 100 years and can be reassuring in times of uncertainty.
You can read more advice from investment gurus on investing during difficult times on our website.
3. Work with a financial planner to build a balanced portfolio
Working with a financial planner who understands your circumstances, goals, and the wider market can be very helpful in reducing the influence of emotions on your investment decisions. This is because they can help you to build a balanced portfolio that includes a range of investments in a host of different sectors and industries.
By diversifying your portfolio and balancing it in accordance with the level of risk that you feel comfortable taking with your wealth, you can feel confident in the potential of your investments to grow over time and help you to achieve your goals. This is because if an investment in one sector doesn’t perform as well as you hoped it would, an investment in a different sector might have generated a better return, potentially offsetting any losses elsewhere.
You should also consider reviewing your portfolio with your planner at regular intervals to ensure it remains balanced. There may be times when you need to make changes, as your goals and preferences are likely to change through each stage of life. But these shifts should always be made with your long-term goals in mind, rather than as a reaction to any short-term worries.
4. Consult your financial planner when you’re feeling concerned about your investments
If a big event does occur that causes you to feel concerned about your portfolio, consult with your planner for advice before making any changes.
Recent events like the Credit Suisse and Silicon Valley Bank collapses can be scary for investors. Instead of dealing with this fear by yourself, it could help to talk to someone who has seen events like this happen before and can reassure you about the likely long-term effects, if any, on your own portfolio.
Get in touch
If you’d like help creating a balanced portfolio that has the potential to help you achieve your financial goals as an expat in Singapore, we can help. Either contact your financial planner directly, email us at hello@ascentawealth.com or fill in our online contact form to organise a meeting and we’ll get in touch.
