Behavioural Finance Focus: Recency Bias and Four Solutions

In Behavioural Finance the cognitive bias known as Recency Bias can impact both investors and traders in quite a dramatic way. In this article, we will take a closer look at the concept of Recency Bias, draw out its link to problems such as Style Drift, and then give you four practical steps to better manage it.

What is Recency Bias?

Recency Bias is the tendency to think recent events, patterns, trends or data are more important than such that are older. We tend to think recent events have a greater predictive or probabilistic value that they should.

As an example, a trader of indices may think recent chart patterns, such as a Candlestick reversal pattern on a daily chart (D1) may have more weight than such on a longer term or a higher chart, such as the weekly chart (W1). Similarly, an investor in stocks relying on recent fundamental data, such as a recent earnings report, may think this outweighs a longer term average or trend of earnings, say over the last five or ten years.

Problems Arising from Recency Bias

Relying too heavily on recent data can seriously hurt our decision-making. As skilled investors and traders we need to be careful we do not think recent data, or data over a small sample set, is more important. For instance, we can think ‘the tide has changed’, or ‘things are different now’. These thoughts often flow from trying to predict the future, rather than anticipating it and relying on sound probability based thinking.

If we think in terms of probability, then the Recency Bias is clearly wrong. Relying on a small, recent sample set should always have less weight in our decision-making than relying on a larger sample set over time. It seems the Recency Bias is linked to the need to be ‘right’ and trying to predict the future, rather than probability based thinking. The shift here is important for any successful investor or trader.

The other main problem Recency Bias trends to cause is known as Style Drift. Style Drift is when we move from one methodology or strategy to another usually trying to find a ‘perfect’ strategy. The drift is often driven by recent data, and not a sound analysis of longer term data. Any major change to a strategy or plan should only occur after looking at a large sample set, and also allowing for changes in the dynamics of the relevant market. The latter point is quite relevant in equity markets of late, such as the S&P which has moved into a volatile ranging pattern in recent months, which is quite a change from its earlier steady, classic uptrend.

The problem of Style Drift can be quite insidious, especially for traders who rely on finely-tuned technical (chart based) set ups. One can go in circles forever if we regularly jumpy from set up to set up, or strategy to strategy. It is best to build a robust system based on sound over-arching principles that are adaptive to different market conditions or types.

Solutions to Recency Bias

We can identify four ways to better deal with the Recency Bias. Like most of the recognised cognitive biases, maybe we can never eliminate the issue, just find ways to manage it, and build a process around the solutions. Here are four solutions that we trust will assist-

  1. Time Span of the Data Set. Identify the time span of the data set you are relying on in your decision-making. Is it long term or short term? Naturally this will vary between traders and investors and in terms of their strategies. However, by making the time frame explicit, we bring it out into the open, rather than just assume the data is ok.
  2. Adequacy. Determine if the time span is adequate for decision you are about to take. For example, if you are a long term investor in stocks, applying a simple buy and hold strategy with an exit rule that says, you will exit if your stock and the relevant index fall into a validated downtrend, then defining the downtrend should best be done on the higher charts such as weekly (W1) or monthly (M1) charts, rather than shorter term charts, such as the daily chart (D1).
  3. Major Changes are Conditional. Dealing with the problem of Style Drift, have a rule or guideline in your trading/investing plan that says any major change or shelving of your strategy will be conditional on a sound length of time, such as 6 or 12 months. For traders, the condition might also include the number of Draw-Downs that occur in say a month or a quarter. Whatever it is, ensure that it allows the market to ‘breathe’, so you do not allow fear to creep it. You want the major change to be exhaustively proven, allowing for changes in market conditions.
  4. Document. In all cases document everything, so you can review your thinking. Document your reasons in say a Trading/Investing Journal, and naturally track your results in a spreadsheet or like software through regular reviews such as a Monthly Investing/Trading Report. Documentation breeds objectivity.

Conclusion- Managing the Self

You will see that these solutions are very much focused on managing the self. Often the work of an investor or trader is undertaken in isolation, so problems such as the Recency Bias can creep in, often unknowingly, often subconsciously. By managing the self, by managing the mind, through professional processes, we can perform better and achieve longer term consistency in the markets.

Lee Spano, Founder & CEO

Creatness International, www.creatness.com

© Copyright Lee Spano. All rights reserved.