Recency bias is a cognitive error identified in behavioral economics whereby people incorrectly believe that recent events will occur again soon. 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 poor short-term decisions that deviate from their financial plans. These short-term decisions can have a very negative impact on your portfolio over the long-term.
After a year when market returns were dismal (S&P 500 down ~19%), I think it’s a good time to put some perspective on bull and bear markets. The chart below shows the length and returns of bear and bull markets from 1926 to 2018. The average bear market lasted 15 months with an average cumulative loss of 35%. The average bull market lasted 51 months with an average cumulative total return of 175%. The stock market has gone up 69% of the years on record and has fallen 31%.
Source: Russell Investments
The poor decisions with recency bias cut both ways. During a market downturn, investors want to get out as they think it will last forever and will never come back. On the other hand, when the market is in the middle of a big rally, investors don’t want to miss out and want to go all in, often increasing the risk they are taking and getting in at the last stages of the rally. Getting all in at the peak of a market can have an equally bad effect as getting out at the bottom.
If you miss just a few of the best days in the market there is a big negative impact on long-term results. Over the past 30 years, missing just the best 20 days in the market took the average annual return down from 7.2% to 3.2%. Furthermore, 78% of the stock markets best days occur in a bear market or the first two months of a bull market. It’s important to have a portfolio of stocks and bonds of high quality companies and stay invested over the long-term.
Have a plan and stick with it – After the past year of volatility, it’s a good time to re-assess your risk tolerance. If you can’t sleep at night, it may be better to adjust your asset allocation to something more conservative. Sure, you may get lower returns during the up markets, but you most likely will have a lower draw down when in a bear market. Make sure your risk tolerance is in line with your financial goals. In most cases, your long-term goals won’t depend on whether or not you have a couple huge years in the market. Slow and steady wins the race. If you always swing for a home run in the stock market, realize that with a higher return comes higher risk!
Lastly, research shows that diversification in asset classes, economic sectors, and geography can help reduce volatility in your portfolio and help returns at the same time.
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