The Trouble with Recency Bias, According to Fisher Investments UK

In Fisher Investments UK’s experience, investors often think what just happened will continue happening. Behavioural finance—a school of thought in investing that studies the relationship between human behaviour, feelings and money—has a term for this: recency bias. Here is a closer look at it—and its potential pitfalls. We think this is important for investors to be aware of, especially in a tumultuous year like 2020.

Recency bias is the extrapolation of the recent past into the future. In the investing universe, we have seen this manifest in numerous ways. For instance, if equities were down recently, recency bias may convince some investors the downward trend will continue. Similarly, recency bias during a positive streak may lead some to project future gains. This thinking can apply more narrowly, too, including to individual country or equity sector performance and economic data. For example, if gross domestic product (GDP, a government-produced measure of economic output) slows or contracts, recency bias may have people penciling in longer-lasting economic weakness.

We think 2020 has shown several examples of recency bias at work. Earlier in the year, headlines in financial publications we read regularly posited the bear market (typically a broad equity market decline exceeding -20% with an identifiable fundamental cause) would persist for a while after its actual end in late March. Similarly, when economies worldwide officially entered recession (a period of contracting economic output), some commentators projected the pain would last beyond 2020, with an eventual recovery taking years to regain pre-pandemic activity levels. Several months later, some experts have already begun updating their dour projections. The International Monetary Fund (IMF), a supranational economic organisation, upwardly revised its 2020 forecast for the global economy due to better-than-expected developments between April and September.ⁱ Similarly, the Central Bank of Ireland now estimates full-year Irish GDP growth of 0.4%, a meaningful update from its July projection of a -9% decline.ⁱⁱ The latest example of recency bias we have observed: Some interpreted the Tech sector’s September volatility as a sign of more turbulence to come—yet another case of presuming the past determines the future.

Whilst what just happened often dominates headlines, Fisher Investments UK’s research shows equities are forward-looking, meaning they focus most on the economic and political factors impacting corporate profits over the next 3 – 30 months. For example, economically, what are credit conditions like? If businesses are finding it difficult to borrow, that could signal slower economic growth ahead as companies have less funds to deploy on new projects. Politically, what is the likelihood governments in major developed economies pass legislation that could introduce uncertainty or create winners and losers? Moreover, how do these economic and political factors align with investor sentiment?

Past prices hold little influence over these equity market drivers, in our view. If they did, simple logic dictates well-performing countries and sectors should continue doing so without interruption—and vice versa for poor performers. However, Fisher Investments UK’s research shows leadership rotations happen. Starting in 1999, the new Information Technology sector vastly outperformed global equities during the bull market that ended in 2000.ⁱⁱⁱ But during the subsequent bear market, Information Technology suffered greater losses than global equities.^iv The sector also underperformed global equities during the following global bull market.^v Those whose recency bias extrapolated Information Technology’s late-1990s robust gains into the future would have been in for a rude awakening for much of the next decade. History tells a similar tale for countries. Non-US equities posted superior returns to US equities during the 2003 – 2007 global bull market.^vi Following the 2007 – 2009 bear market, those with recency bias may have projected non-US equities’ past leadership into the next bull market. Yet from 2009 – 2019, US full-year returns beat non-US returns in 8 of 11 calendar years.^vii

In Fisher Investments UK’s view, recency bias can adversely affect investors’ decision-making, causing them to chase past returns or miss opportunities because what just happened colours their perception. To combat this tendency, ask yourself: Is your investment decision based on an outlook that has nothing to do with past performance? If your investing thesis is based more on what just happened than what looks probable ahead, recency bias may be at work. Also consider whether your decision is aligned with your personal long-term investment goals and objectives. If recency bias is stirring strong emotions—whether fear or greed—go back to your long-term investment plan. Would acting on the recent past set back your progress? Based on Fisher Investments UK’s experience, successful investing requires keeping emotions out of your decision-making—and being aware of recency bias is a big step towards keeping it in check and staying disciplined.