Economics and financial theories have considered human mind a rational one which is now accepted as irrational. For example; since childhood we know that ‘Early to bed and early to rise’ is a good thing to do; one should eat healthy home cooked food, salads are good for health and so on. A rational mind which has all this information would decide for best available option but we all know what mostly happens. Now, as we accept irrationality of human mind, it is important to understand that it is applicable to investment choices and decisions as well. We strive to caution our investors towards these behavioural biases and empower them to make better investments. Recent market ups and downs panicked many investors who felt low on confidence. It propels us to understand Recency bias and make our investors aware about it.
Understanding Recency Bias
Recency bias lures investors into buying recent high performing funds which may be at their maximum valuations which is not an apt thing to do. Belief-Adjustment model by Hogarth and Einhorn describes how we process received information. One can take initial piece of information and then aggregate all information in end to take decision at the End of Sequence and here the initial information takes more weightage. However, when processing is done Step by Step, each new information forms different impression and the belief is updated which creates impression of latest information being most important; & so Recency bias leads to overweigh most recent information available to us because that information is fresh in our mind. We regularly encounter these phenomena in our day to day life. For example;
- During the appraisal phase in a company employee tend to put in more hours at work and tend to build a positive image which could lead to managers evaluating employees on their recent performance rather their performance during the entire year. Similarly, Investors tend to believe that the recent good performance is an indication of a similar performance in the future.
- A trader made profit on 32 of 40 trades, but if loss making trades are last 8 continuous trades, a distorted view and emotional mistakes are bound to happen. Similarly, if last 8 trades were profitable, trader would feel happy and confident. These biases do not let investor to stick to his trading or investment plan which might result in huge losses.
- It is a recurring phenomenon in film industry where after one huge hit actors demand more fees, even though they cannot guarantee a hit film but producers pay them as they also want to cash in on public’s short-term euphoria around popularity of actor. It is no rocket science to understand that if an actor who gave one (Insert Rs symbol) 400 cr film in 3 years or someone like Akshay Kumar who gave 10 hits in three years making (Insert Rs symbol) 1000 cr, is more successful.
Be Mindful to Avoid It!
In case of mutual funds, mindset has to be of long-term considering end to end information sequence and accumulating wealth over time. It is fine if your fund’s six-month return is 1% less than any xyz fund. Consider other things like Fund Manager, Portfolio, Management Strategy, Economic Situations, Goals and if this comes as too heavy to do; One can always lean on INVESTOCAFE for the expertise of selecting best funds based on your goals and preferences. In the era of Google, everyone has the access to data of past fund performance but making use of it as an information and forecasting future performance is critical. Without being overconfident[i], investor can leave this performance estimation to INVESTOCAFE which considers all round evaluation criteria for selecting funds. It will also save you from chasing trends and switching funds now and then unnecessarily.
Data Source: (www.bloombergquint.com, 2019)