This Mental Error May Seriously Undermine Your Wealth Building Efforts

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Most of us are familiar with the pioneering brilliance of Sigmund Freud. Yet fewer are aware of the equally brilliant Hermann Ebbinghaus.

Ebbinghaus was a German psychologist of the late 19th century. He invented the idea of the learning curve. He helped create the first experimental studies of memory. He even helped lay the foundation for modern day intelligence testing.

Yet perhaps most important to modern day investors, he also created the concept of recency bias.

The idea is elegant, yet simple -- we tend to privilege recent events over older events when making decisions.

In the investing world, that's a problem. When we overweight recent events, we can make ill-advised decisions. Recency bias is one of the primary reasons investors get caught buying high and selling low. Rather than rebalancing and thinking long-term, we make poor decisions while succumbing to our own biases.

Most of us are not adept with managing probabilities. We tend to estimate them not on long-term experience, but on recent outcomes.

That's precisely the wrong mindset for success in the stock market. The savvy investor thinks of the big picture. The long time horizon.

Yet many of us just can't help ourselves. It's akin to watching a coin come up heads ten times in a row. We feel, intuitively, that the 11th flip will be tails. Yet simple logic tells us each flip is an independent event. The 11th flip is a 50/50 bet -- it just doesn't seem that way.

That's how recency bias works. It's not an easy trap to avoid. It's difficult to make rational decisions when every fiber of your being rebels against it.

Have you ever watched a stock skyrocket and felt a compulsion to buy? That's recency bias in action. Whether we like it or not, recent events take up more of our mental bandwidth. The trick is to recognize this and make the proper adjustments.

A study by a University of California finance professor named Terrance Odean shed light on recency bias in action. Odean found that two thirds of stock trades are buys made the day after a stock is ranked as a top performer. These stocks underperformed the market by 1.6 percent over the next 30 days.

The stocks these investors sold? You guessed it -- they outperformed.

Research has shown that short-term stock trading can cost the typical investor up to 40-percent each year. Yet the stock market has never lost money over a 20 year period.

Think about that the next time you're tempted to chase fleeting market gains. That's the true cost of recency bias.

Other biases at work

Unfortunately, recency bias isn't the only self-imposed mental stumbling block most investors face. Overconfidence is another common and deeply damaging trait many investors display. Numerous academic studies have measured the almost absurd lengths by which we overestimate our own abilities. This inflated self regard certainly extends to the wealth building arena.

Today small investors have more data at their disposal than ever. Yet even with these tools, the odds of beating the market are slim. After all, many professionals -- who study stocks daily -- can't outperform the S&P 500. So why would any amateur?

Confirmation bias is another trouble spot for most of us. The idea here is simple -- we seek out evidence to support our own biases. We then disregard evidence that counters our own existing beliefs.

The most problematic aspect? We often aren't even aware we're doing it. This is bad news when it comes to investing. The right approach is a flexible one. Instead of searching for data to support your own views, consider all information without prejudice. Your portfolio will benefit greatly.

Finally, most of us have an aversion to letting go of sunk costs. We don't like to admit failure. We hope against hope things will still turn around. Yet blind refusal to accept the reality of the situation is often far more damaging. Don't let a bad investment become a crippling investment. Sometimes a write off is needed if you want a fresh start.

Plan for action

We're all riddled with innate biases. Even the most clear-eyed and rational investor has a blind spot. Yet by recognizing this fact, we can provide ourselves with a competitive advantage over those who aren't looking inward. 

Avoiding cognitive biases entirely isn't realistic. Yet here are a few steps you can take to mitigate the damage:

  • Remember that in memory studies people always recall the last item most vividly. Before making a financial decision, review the long-term historical trends.
  • Do not stress personal experience over hard data. This is a common trap.
  • Take advantage of recency bias effects in others, or in the market. After a major correction, most investors will overreact. The reverse holds true.
  • Apply a systematic set of principles. Research and data can counter effect of personal biases.

If you follow these steps, you'll gain considerable (though not total) immunity from crippling bias-related errors.

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