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Recency Bias Linked With Other Pitfalls

Clients who suffer from recency bias may also be subject to outcome, representativeness, and illusion of control bias.

Michael M. Pompian, 06/21/2012

This month's article is the ninth in a series called "Managing Behavior in a Volatile Market" and Part II of a discussion on recency bias. This series provides data and insight into the identification of key behavioral biases and also shows how to manage client behavior and emotion in this highly volatile market environment.

A substantial part of this series will be a review and analysis of answers to behavioral questions that were completed by a diverse set of 178 individual investors in 2011. The investors polled were not subscribers to Morningstar.com and/or Morningstar investor newsletter publications like the last survey, but they fit a similar profile in terms of investment objective and investor description.

By way of background, the survey questions were written to identify 20 key behavioral biases that I outline in my book, Behavioral Finance and Wealth Management. The second edition of the book, with updated biases and new case studies, just hit the cyber-market.

As noted in earlier articles, the intent of the survey was twofold. First, I wanted to identify the most prevalent biases ("Primary Biases"), so advisors would know what to look for when working with their clients. Second, I wanted to identify what secondary behaviors ("Secondary Biases") might also be lurking behind these primary biases. In other words, if client Smith has easily recognizable bias X, what other of the 19 biases might client Smith also be subject to?

The purpose in doing this is that advisors can hopefully recognize not only primary biases, but secondary biases as well. Often it is the unrecognizable biases that can cause substantial harm when attempting to keep clients on track to attaining financial goals. Advisors can hopefully gain significant insight into a range of a client's behavioral tendencies simply by being aware of a single common bias.

In order to rank as a primary bias, 50% or more of respondents need to answer at least "Agree" or "Strongly Agree" to a question designed to identify a certain bias.

There were seven biases that garnered at least 50% positive responses:

Loss Aversion Bias: The pain of losses is greater than the pleasure of gains

Anchoring Bias: Getting "anchored" to a price point when making an investment decision

Hindsight Bias: Believing that investment outcomes should have been able to be predicted

Recency Bias: Taking investment action based on the most recent data or trend rather than putting current situations into historical perspective

Representativeness Bias: Making current investment decisions using the results of past similar investments as a frame of reference

Status Quo Bias: Not taking action to change one's investment portfolio (i.e., doing nothing when prompted to do so)

Regret: Past (poor) decisions affect future investment decisions

When you are providing advice to clients, at a minimum you should be looking out for these seven biases, as they are likely to be the most commonly encountered. For example, let's say you identify that a client is loss averse. What are the other irrational biases they might be subject to? This series is intended to help answer this question for the seven biases listed above and provide tips on overcoming them.

In this article we will review the biases associated with recency bias. Sixty percent of 178 people responded that they agreed or strongly agreed to a question asking them if they were subject to recency bias (i.e., when making an investment decision, investors put extra weight on events that have occurred more recently, such as following a recent trend, rather than recalling events that occurred in prior time periods). Of that group, at least half were also subject to the following six biases:

1. Hindsight (65%)
2. Anchoring (63%)
3. Loss Aversion (60%)
4. Outcome (57%)
5. Representativeness (55%)
6. Illusion of Control (50%)

For example, of the respondents who said they were subject to recency bias, 65% of them were also subject to a question designed to identify hindsight bias, and so on for the other five biases.

Below, I will provide commentary on the last three of these biases: outcome, representativeness, and illusion of control. I will discuss why these biases are likely linked with recency and what you can do to counsel a client who has these biases.

Recency and Outcome
Recency and outcome biases certainly go together. Clients subject to outcome bias focus on the outcome of an event as opposed to the process by which the result was achieved. For example, an investor might think: "This manager had a fantastic five years; I am going to invest with her" rather than understanding how such great returns were generated or why the strategies used by other managers might not have had good results over the past five years.

Clients subject to recency bias put extra weight on events that occurred more recently rather than events that occurred in prior time periods. Putting these two ideas together, clients may look at a recent outcome, such as the stock market going up 20% in the last 90 days, and decide it's a good time to invest. They may believe this falsely rather than looking at historical valuation information and/or doing diligent research. When this happens, they may disregard important considerations such as the prospects for the investment or valuations, which may be key drivers of future investment success.

Advice: The natural advice to those subject to outcome bias is to focus not so much on the outcome of an investment opportunity but the process by which the investment decision is being made. If one makes money but did so in a way that did not follow a structured process, then this is luck. Conversely, if one does not make money in a certain period but had a sound reason for making the investment, then this is likely a more reliable investing process that can be counted upon over the longer term, even if it didn't work out in the short term.

Recency and Representativeness
Recency bias and representativeness may not appear naturally tied. Let's dig into the details.

As noted, clients subject to recency bias put extra weight on events that occurred more recently rather than events that occurred in prior time periods. Clients subject to representativeness bias use prior experiences as a frame of reference for current decisions. (Technically speaking, representativeness bias is a belief perseverance bias in which people, when confronted with new information, use pre-existing beliefs to help classify the information, even if the new information does not necessarily fit an existing belief.)

Putting these two ideas together, clients often have their own reference points or lenses through which they judge current investment decisions--and these views can be tainted by looking at recent information. When this happens, they may attempt to put decisions in context based on current trends in the marketplace. This can be "hazardous to your wealth" because often investors who dive into asset classes that have had strong recent performance end up being disappointed because they pay too high a price upon entry. One example is real estate in the last market cycle. Many who bought speculative real estate in 2006-2007 may still not be back to even.

Advice: As I have noted in past articles, advisors need to encourage their clients to judge every investment idea on its current merits, and not based on past experiences. Not always easy! Investment ideas and asset classes go through cycles of attractiveness and unattractiveness. Be flexible in your thinking! And most importantly, pay attention to valuation.

Recency and Illusion of Control
Recency and illusion of control are quite different biases but can certainly be connected. Investors who are subject to illusion of control overestimate their ability to control events; for instance, they may feel that they can control outcomes that they demonstrably have no influence over, such as the success of short-term trading strategies. As noted, clients subject to recency bias put extra weight on events that occurred more recently rather than events that occurred in prior time periods. For example, suppose Chris buys a stock based on a chart he saw on an investment website that showed the stock's six-month return. Chris may think that he can successfully trade the stock because he believes the most recent trend will continue, and why wouldn't he make money? He has proven to be able to influence the success in other endeavors in life, such as business, so why shouldn't he be able to be a successful investor?

Advice: Illusion of control can be a powerful bias. Those clients who have been successful in controlling events outside of investing often feel as though they should be able to be successful investors. When you couple this idea with recency bias, bad decisions may be the result. One needs to be introspective and try to determine if the decision being made is a potentially biased decision. Investments based on tried-and-true principles such as valuation are often better decisions.

Hopefully you have learned something about recency and the biases connected with it. When you encounter a client with recency bias, think about the biases you have read about in this article. It might help to build a better client relationship! In next month's article, we will review the biases associated with representativeness.

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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