VIDEO: Retirement Investing Pitfall #5 – Recency Bias

 

This week we will discuss Retirement Investing Pitfall #5 from my book Plan Smart Retire Right. This pitfall is called Recency Bias. We’ve all heard the phrase “past performance is not indicative of future results.” However, many investors fail to take it seriously when making decisions about their investment strategy. Recency Bias is this is the tendency of people to purchase investments which have recently performed well, or stay away from investments that have performed poorly.

This type of behavior typically manifests in people chasing the top performing stocks, mutual funds, or ETFs with the belief that the performance is likely to continue going forward. Also, recency bias can be seen when investors pull out of a falling market and then when the market turns, they sit on the sideline afraid to jump back in. Often, these exaggerated moves up and down happen because many investors are trying to time the market and chase returns. However, often the opposite can happen, and the top performing investments in any one year (or years) may turn out to be poor performers in following years.

As a financial advisor, a big part of my job is explaining effects like this to clients whom are tempted to invest their hard-earned savings based on recent performance, rather than taking long-term considerations into account. Investors who chase the latest hot-performing investments run the risk of hurting the long-term performance of their retirement savings and missing out on the power of compound interest. Investments that outperform over a certain period don’t typically run straight up forever, and can often underperform over a period of time that directly follows. In most cases, the saying holds true: “what goes up, must come down.”

To avoid falling victim to recency bias, it’s important to view the performance of asset classes over an extended time period, perhaps a 10-year time frame at a minimum. This means you need to be able to stick to your long-term strategy, be patient, and ride out the ups and downs. Markets are cyclical, and investing a disproportionate amount in one sector or stock on the basis of recent outperformance subjects your portfolio to the risk of underperforming in the next period. Since markets on any given day could become overvalued, undervalued, or anywhere in between, it’s important to not let recency bias dictate your moves.

Broadly diversifying your portfolio should reduce the risk of this type of subpar performance, and offers a more measured and disciplined approach to achieving your retirement savings goals.

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