What Do Summer Vacation Plans and Investing Have in Common?
Probably very little! As we think about our summer plans, we often reflect on past experiences to help us make future decisions. We may research the highest rated restaurants, the most consistently clean hotels, or the best beach or lake for families. This makes logical sense. The experiences that were enjoyable in the past will most likely be enjoyable in the future. The restaurant that received five stars will likely continue to serve consistently good meals.
As decisions for vacation planning become more complex, we may seek the help of experts. For example, if our summer vacation is to Disney World, it can be incredibly helpful to consult a Disney expert - someone who has been to the park before and knows how to find the shortest lines and the best meals.
This rational decision-making process has served humans well for thousands of years, and includes:
1. Identify a need or a want
2. Conduct an analysis
3. Make an informed decision
4. Evaluate our decision and reflect on how satisfied we may be
Rankings and experiences have served us well in the decision-making process. It even works when we think about the best colleges. Schools that have been highly ranked tend to stay highly ranked, meaning the experience of others and rankings remain relatively consistent from year to year. These tools provide confidence in our decision-making process.
But an interesting thing happens in the investing world. The decision-making process we use for the real world may be detrimental to our investment decisions. That’s because recency bias in investment decisions may adversely affect our success towards our plan.
What is recency bias?
Recency bias is the tendency to place too much emphasis on experiences that are freshest in your memory (even if they are not the most relevant or reliable). Would you want to go for a long ocean swim after watching Jaws or Shark Week on the Discovery Channel? Probably not, even though the actual risk of being attacked by a shark is infinitesimally small.
- With recency bias, people tend to put too much emphasis on recent events.
- This bias may lead investors to think that a current stock market downturn or rally will extend into the future.
- Recency bias can lead investors to make short-term decisions that deviate from their financial plans.
Why does it matter?
Consider the cost of chasing hot investment trends: in 2019, financial services was one of the best performing sectors in the S&P 500 Index, delivering an annual return of 32%. Anyone who subsequently purchased financial services stocks may have been disappointed that the sector was down -2% in 2020, when the S&P 500 Index returned more than 18%.
The Takeaway
Short-term market moves caused by recency bias can reduce long-term results, making it more and more difficult for investors to achieve their long-term financial goals.
As we can see from the graphic below, a favorite share at Charter Oak, the best performing investment from one year may be the worst performing investment the next year.
The above is why the advisors at Charter Oak remain staunch believers in diversification – owning multiple different kinds of stocks and bonds. We all have our biases. It’s part of being human. Our goal is to recognize these biases and help our clients stay committed to a long-term, goal-focused, diversified investment strategy.
“Don’t look for a needle in the haystack. Just buy the haystack!”
- John C. Bogle, Founder of Vanguard Investments
It is a pleasure and a privilege to be your trusted advisor. We send our best in the coming weeks of summer 2023, may you take some time for vacation and memory-making with family and friends.