recency_bias

Recency Bias (also known as the 'recency effect') is a pesky mental shortcut from the world of Behavioral Finance where we give disproportionate weight to recent events, convincing ourselves that the latest trends will continue indefinitely. Our brains are hardwired to think, “What happened yesterday will happen tomorrow,” which might have been useful for our ancestors tracking weather patterns, but it can be devastating for modern investors. For example, after a few weeks of a soaring stock market, recency bias whispers in our ear that prices will only go up, making us susceptible to buying into an overvalued Market Bubble. Conversely, after a sharp market drop, the same bias screams that the world is ending, tempting us to sell everything at the bottom and lock in our losses. It’s the financial equivalent of packing only shorts for a year-long trip because you left on a sunny day. This cognitive glitch causes investors to extrapolate the immediate past into the distant future, often leading them to buy high and sell low—the exact opposite of a sound investment strategy.

Why are our brains so easily fooled? Recency bias is a type of cognitive heuristic, a mental shortcut our brain uses to make quick judgments. This system is designed for efficiency, not for accurately forecasting the S&P 500. Recent information is more easily recalled from our memory, so our brain assumes it must be more important. When a stock like NVIDIA has a spectacular run, the vivid, recent memory of those gains overshadows decades of data on market cycles and Mean Reversion. The emotional impact of recent gains (excitement, greed, fear of missing out) or losses (fear, panic) further cements this bias, turning a simple memory quirk into a powerful and often destructive financial force. It’s a feature of our brain’s operating system that requires a conscious override from the logical, analytical part of our mind.

You don’t have to look far to see recency bias wreaking havoc on investor portfolios. It’s a timeless mistake that repeats with every market cycle.

The Dot-com Bubble of the late 1990s is a textbook case. Investors saw tech stocks posting unbelievable gains month after month and, driven by recency bias, concluded that traditional valuation metrics no longer applied. They piled into companies with no profits and flimsy business plans, assuming the recent rocket-ship trajectory was the new normal. They were, in effect, driving while looking only in the rearview mirror. When the bubble inevitably burst, fortunes were wiped out because investors had mistaken a temporary mania for a permanent trend.

Consider the Great Financial Crisis of 2008 or the flash crash of March 2020. As markets tumbled, the daily news was filled with panic and dread. Recency bias took hold, convincing many investors that the stock market was a one-way ticket down. They sold their holdings near the bottom, crystallizing their losses. These investors then watched from the sidelines as the market staged a powerful recovery, having let the pain of recent events dictate a poor long-term decision.

A company reports a single, stellar Earnings Per Share (EPS) number, beating all expectations. The stock jumps 15%. Recency bias leads investors to believe this new, higher growth rate is permanent. They bid the price up to unsustainable levels, ignoring that it might have been a one-off event. The same is true in reverse: one bad quarter can cause a panic-sell, even if the company's long-term Fundamental Analysis remains solid. Value Investing teaches us to look at the entire story, not just the last chapter.

Fortunately, you are not helpless against this cognitive foe. A disciplined Value Investing framework is the perfect antidote.

Instead of focusing on the last three months of a stock's performance, look at the last ten years.

• Does the company have a durable Competitive Advantage?
• How has it performed through different market cycles?
• Is its current price justified by a decade of earnings, not just a single quarter's results?

A long Time Horizon starves recency bias of the short-term data it feeds on.

Before you buy a single share, write down your investment thesis. Why are you buying this company? What is its Intrinsic Value? What are the key drivers for its success over the next five years? This simple act forces you to base your decision on logic and research. When the market later gets euphoric or panics, you can reread your notes. This grounds you in your original, well-reasoned thesis and helps you resist the emotional pull of recent events.

Warren Buffett’s famous advice to be “fearful when others are greedy, and greedy when others are fearful” is a direct assault on recency bias. Contrarian Investing involves training yourself to do the opposite of what the crowd, blinded by recent events, is doing.

1. When the crowd is euphoric after a long bull run (recency bias: “it will go up forever!”), a contrarian looks for overvalued assets to avoid or sell.
2. When the crowd is panicking in a crash (recency bias: “it will go to zero!”), a contrarian, armed with a strong balance sheet and a focus on long-term value, goes shopping for bargains with a Margin of Safety.

By consciously questioning the prevailing narrative, you can exploit the mistakes that recency bias causes in others and protect yourself from making them. Think of Benjamin Graham's allegory of Mr. Market: your goal is to ignore his manic-depressive mood swings and focus only on the price he offers relative to the underlying value.