A Case Study of How Recency Bias Destroyed Investor Wealth

The investor’s chief problem – and even his worst enemy – is likely to be himself.

- Benjamin Graham

Many investors are performance chasers, tending to buy (high) a fund after a period of good performance and tending to sell (low) after a period of poor performance. This results from the behavioral error known as recency bias – one of the 77 errors discussed in my book, Investment Mistakes Even Smart Investors Make and How to Avoid Them. Recency bias is the tendency to overweight recent events/trends, projecting them into the future, while ignoring long-term evidence.

Buying after periods of strong performance (when valuations are higher and expected returns are now lower) and selling after periods of poor performance (when valuations are lower and expected returns are now higher) is not a prescription for successful investing. Yet, because of recency bias, it is the way many individuals invest. What disciplined investors do is the opposite – rebalance to maintain their well-thought-out allocation to risky assets.

Sadly, while most investors consider three years a long time to judge performance, five years a very long time and 10 years an eternity, wise investors know that all risk assets go through even much longer periods of underperformance. Consider that the S&P 500 Index underperformed riskless one-month Treasury bills over the 13-year period ending 2012, the 15-year period ending 1943 and the 17-year period ending 1982. Of course, over the succeeding periods, stocks went on to produce spectacular returns – those that were earned only by staying the course.