Key idea
We assume the recent past will continue. After a good run we expect more gains; after a crash we expect more falls. Both assumptions mislead.
Recency bias is the tendency to give too much weight to what just happened. If markets rose for a year, we feel they will keep rising; if they fell, we feel the fall will continue. We project the recent trend forward, even though markets are cyclical and trends reverse.
Where it leads investors astray
After a strong bull run, recency bias breeds overconfidence: investors pile in, expecting the good times to roll on, right before a correction. After a crash, it breeds despair: investors stay out, expecting more pain, right before the recovery. In both cases, the recent past is a poor guide to the near future.
After gains
we expect more
After falls
we expect more
Reality
trends reverse
The defence
The antidote is to zoom out. A single year, good or bad, tells you little about the decade ahead. Judging investments over long periods, and sticking to an allocation set for the long term, immunises you against overreacting to the latest stretch. The recent past feels vivid and certain; it is neither a promise nor a warning.
Whenever you catch yourself thinking "this will surely continue," pause. That feeling is recency bias, and it is usually loudest right before the trend turns.
Finished reading?
Marking this complete counts today, and your streak becomes day 1.