There’s nothing like a blizzard to drive up demand for snow tires. At work here is a phenomenon known as recency bias, which is our tendency to believe that something is more likely to happen again because it occurred in the recent past. The inverse is also true: the longer it’s been since an event took place, the less likely we are to believe it will happen in the near future.
When it comes to investing, recency bias often manifests in terms of direction or momentum. It convinces us that a rising market or individual stock will continue to appreciate, or that a declining market or stock is likely to keep falling. This bias often leads us to make emotionally charged choices—decisions that could erode our earning potential by tempting us to hold a stock for too long or pull out too soon.
Recency bias tends to be exacerbated during periods of large market moves. Before the dot-com bubble burst in 2000, for instance, rapidly appreciating stock prices convinced many investors to keep riding out the market. Similarly, many others who sold off shares during the global recession of 2008–2009 missed much of the market rally that followed.
Maintaining a long-term investment plan is one of the best defenses against recency bias. Your long-term asset allocation targets should reflect your investing goals, tolerance for risk and cash needs. Periodically, you may need to reassess your expectations for the long-term performance of various asset classes, but any resulting changes to your allocation should be modest. Use valuation metrics such as price-earnings ratios to bring objectivity to your analysis. Also, think ahead about how you should respond if a position exceeds your expectations or suffers a surprise decline.
The recent past may be fresh in your mind, but putting it in the proper context can keep it from having an undue influence on your investments.