It’s no secret that investors tend to chase investment performance, in fact most mutual funds and investment companies count on it. Flows into mutual funds are highly correlated to the funds performance in the prior four quarters. Thus, investors piling into an investment shortly after peaking and about to reverse lower is a constant habit and source of poor performance. Because the investment has been climbing higher recently, investors believe that will remain the case. This is the recency bias, the belief that the near term recent performance, is more valuable than the long term performance.
Recency bias undoubtedly skews how investors evaluate the longevity of economic cycles. This causes them to find conviction in a bull market even when they should grow cautious of its potential deterioration. Inversely, they avoid acquiring assets in a bear market because they remain overly pessimistic and discount the urgency of a recovery. The feeling that our minds create about the most recent of events is an irrational overweighting of those events over the long term history of an investment. This causes investors to be sluggish in their investment decision, and gets them to incorrectly gauge the value of new, and likely more important changes in the underlying mathematics and economics of an investment.
Not only can recency bias affect the performance evaluation of a stock, they will also reflect that on the advisor. Investors will routinely see under performance of an investment advisor for years, until the advisor is correct on an investment.
Recency bias is more discernible when discussing the timing of a market, it is often measured and witnessed through momentum indicators that disproportionately weigh the volume of transactions on a stock, over its fundamentals. Using investors cognitive bias against them, some trading strategies count on direction changes in investors momentum to exploit likely mispriced securities.
Recency bias is likely the most reliable bias to measure in the machinations of the market itself, and several formulas can identify and exploit the convictions associated with this sentiment.