Recency Bias—Part Two
Our previous posting discussed recency bias—the tendency for humans to believe the future will continue much as it has in the recent past. Many investors display this bias via performance chasing, that is, favoring investments that have been performing well recently. Some financial advisors have compared this to driving a car by looking continuously in the rear-view mirror. Your driving will be fine until the road turns.
Santa Clara University Finance professor, Meir Statman has conducted many experiments on investing behavior. Statman analyzed a decade’s worth of monthly surveys of investors. He found that for every percentage point increase in the prior month’s performance of the Standard & Poor’s 500, the number of survey respondents expecting an increase in the following month would also increase by one percent. The survey respondents merely extrapolated the recent past into their expectations for the future.
Some additional research cited in the Journal of Experimental Psychology by Australian professors Peter Ayton and Philip Newall found that this recency bias will persist, even when disclaimers about past performance are provided. The researchers conducted sixty iterations of an experiment (1,600 U.S. participants) where people were asked to choose between Fund A and Fund B. They were provided with each fund’s previous month performance in addition to the fees associated with each choice. The fund returns varied randomly but on average Fund A would outperform over time due to much lower expenses. Surprisingly, a majority of investors selected the more expensive fund, even after viewing the standard mutual fund disclaimer about the failure of past performance to persist. Their tendency to chase recent performance overrode the fact that fund expenses are a better predictor of future results.1
If you would like to learn more about these and other wise financial planning moves, please contact us through our Level 5 Financial LLC website or via phone at 719-323-1240. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
1Thanks are in order to Jason Zweig for his July 23, 2021 Wall Street Journal article entitled “Why Investors Can’t Kick the ‘Past Performance Habit”.