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Recency Bias and Investment Decisions
Behavioral finance (also known as behavioral economics) is the integration of psychology and finance to better understand how people actually make financial decisions. There are many cognitive biases that most of are subject to and I would like to discuss the ‘recency bias’ in this blog post.
The recency bias refers to the tendecy of most of us to place a higher value on events that have occurred most recently than those events that have taken place in the past. A good example is the recent financial shock of late 2008 and early 2009 when the stock market lost nearly half of its value in a very short period of time. Some of the consequences of this recency bias included investors pulling money out of stocks and stock mutual funds in favor of bonds and guaranteed cash investments. These are short-term decisions that can have a very negative impact on long-term financial plans.
For those who were able to ignore the ‘news of the moment’ and stick to their long-term objectives the rewards were quite impressive. From March of 2009 through the remainder of 2009 we saw a nearly 50% increase in equity prices. Of course, sticking with a long-term plan is always more difficult than it sounds. Here are some suggestions:
* Choose the right asset allocation and write down your decisions in a document known as an Investment Policy Statement; by writing down your decisions and signing the document you are more likely to stick with your plan
* As much as possible, turn off the television, radio, and avoid spending too much time on Internet news sites. This obviously takes quite a bit of self-control but it is important to understand how detrimental the short-term news cycle can be to our thinking.
* Make regular contributions to your savings and investment accounts; making these contributions automatically through payroll deduction is the best way of doing this; the same goes for distributions from your accounts if you are retired.
* Review and rebalance your investment accounts on a periodic basis; whether you do this quarterly, semi-annually, or annually stick to the schedule and then ignore your investments until the next review.
Please forward any questions or comments to Ken Weingarten firstname.lastname@example.org.