Assume you are driving in a foreign country for the first time. On your drive you pass an equal number of red and blue cars, but most of the blue cars are seen towards the end of the journey.
Evidence suggests you’re likely to think there are more blue than red cars on the road. This is recency bias – our tendency to use our recent experiences more than distant ones in predicting what will happen in the future.
Getting the colour of cars wrong will have no consequences. However, when it comes to investing, recency bias can prove very costly indeed.
In bull (rising) markets especially, forgetting the past can be dangerous for our wealth. The market has risen so we assume it will keep rising. Many of us keep looking at our rapidly increasing portfolio value and will buy more risky assets.
Recency bias means we forget that markets can also fall and we become overly optimistic as we keep increasing our risk, possibly just as markets move into over-valued territory. The technology boom was one classic example of this behaviour, resulting in devastating losses for many investors.
But recency bias doesn’t just occur in rising markets. More recently, during the global financial crisis, stock markets were making the news on a daily basis, with despair setting in. So although share prices had fallen considerably, many investors assumed the downward trend would continue and took shelter by selling up. But just like they have always done (and sometimes it takes longer than other times), markets settled and resumed their upward path. Those who sold risked realising losses with little chance of making them back.
In our chart below, the blue line indicates the return of a hypothetical portfolio during and after the recent financial crisis. Half of the portfolio is invested in the FTSE 100, with the remaining balance in UK bonds. If investors had panicked and moved their investments into cash - the grey line - at the end of the period they would be down 16% on their initial investment.
However, a closer look shows that those who stayed the investment course would have recovered their losses in a matter of months, and gone on to make a very healthy 67% profit. Not bad for doing nothing.
James Norton is a senior investment planner at investment firm Vanguard UK.