Recency Bias & Perceived Risk
Recency Bias & Perceived Risk
After 2021's gains, investors felt stocks were safe. After 2022's loss, they felt bonds were unsafe. Neither was true; only recent experience changed.
Key takeaways
- Recency bias: the tendency to believe recent events are more representative of the future than historical evidence suggests.
- Investor risk perception follows recent returns, not fundamental risk. After gains, equities feel safe; after losses, they feel dangerous.
- This bias drives terrible allocation decisions: buying after crashes (fear) and selling after gains (complacency).
- The fix is mechanical: ignore perception, follow a pre-set allocation plan, and rebalance regardless of sentiment.
- Long-term successful investors are often those who don't feel their portfolio's recent performance.
How recency bias manifests
2022 Example: Bonds crash 15%, suddenly feel "risky"
For decades, bonds were the "safe" asset. Investors held them for stability in downturns. But in 2022, interest rates rose sharply, and bond prices fell ~15% (inverse relationship). For the first time in 40 years, bond investors watched their "safe" allocation decline alongside stocks.
Result: Articles appeared claiming "bonds are no longer safe" and "the 60/40 portfolio is dead." Investors who'd been 60/40 suddenly wanted to shift to 100% stocks or alternative assets.
But did bonds' risk change? Not materially. Bonds still have:
- Lower long-term returns than stocks (roughly 3–4% nominal, still true in 2024)
- Lower volatility over 5+ years (still true)
- Low correlation with stocks during recessions (still true, though 2022 was an exception)
The perception of risk changed because recent experience (2022 loss) overwrote decades of data (bonds recover, steady income).
2017–2020 Example: Stocks feel invincible
By 2020, after a decade of stock gains post-2008, risk perception for equities was near zero. The S&P 500 had doubled twice, and investors felt stocks were a one-way bet. FOMO (fear of missing out) drove investors to increase equity exposure and reduce bonds.
Result: Just before the 2020 COVID crash, allocation surveys showed investors at near-record equity weightings. The perception was that equities were "proven safe."
Did equities' risk change? No. They still suffer 20–40% crashes every decade. But after 10 years of gains, perception had overwritten this historical reality.
Why recency bias is so powerful
Several factors make recency bias nearly universal:
1. Vividness: Recent events are vivid and emotionally salient. The 2022 bond loss is fresh; the historical record of bond stability is abstract.
2. Availability: Your brain recalls recent events more easily than distant ones. You remember 2022; you don't remember 1995.
3. Pattern-matching: Humans detect patterns in short sequences. Three years of stock gains feels like a pattern ("stocks are safe"), even though 30 years of history show crashes every 8–10 years.
4. Survivorship bias: You remember the portfolio that succeeded; you don't remember the ones that failed because of bad timing. A friend who bought 100% stocks in 2009 and held through 2021 succeeded; you don't hear from ones who did the same in 2007 and panicked in 2008.
5. Emotional weight: Losses loom larger than gains. A 15% loss in 2022 feels more significant than a 20% gain in 2021, even though the net is positive. So the recent loss dominates perception.
The data: how perception diverges from reality
Morningstar and Vanguard have repeatedly measured the gap between investor risk perception and reality:
2007–2008: Equity risk perception was lowest before the crash (investors felt stocks were safe) and highest during/after the crash (investors felt stocks were catastrophically risky). In reality, the risk hadn't changed—the market hadn't become more volatile overnight—but perception inverted.
2010–2019: Equity risk perception steadily declined as the bull market matured. By 2019, investors rated stocks as "moderate risk," even though volatility and drawdown severity are unchanged from 2007–2009.
2020: COVID crash occurred (35% drop in 6 weeks). Perception spiked. By August 2020 (full recovery), perception had already started declining again, even though the underlying risk was identical to 2019 and 2020 pre-crash.
2022: Bond losses resulted in the first negative return for bonds in decades. Investor perception of bond risk spiked from "very low" to "moderate to high." By 2023, as bonds stabilized, perception declined again. The risk hadn't changed; only the recent return did.
The pattern: Investor risk perception is a lagging indicator of recent returns, not a leading indicator of future risk.
How recency bias leads to poor decisions
Decision 1: Buying after crashes (emotional panic)
In March 2020, after a 35% crash, most investors were terrified. Risk perception was at all-time highs. The correct financial decision would have been to rebalance (buy stocks at a 35% discount). But perception of risk was so high that most investors wanted to reduce exposure.
Those who overcame the bias and rebalanced (buying stocks at the bottom) made 40%+ gains by 2021. Those who panicked and reduced exposure missed the recovery entirely.
Decision 2: Selling after crashes (locking in losses)
In 2008, after equities fell 48%, perceived risk was catastrophically high. Many investors sold their equity holdings to "preserve capital." But they sold at the bottom. When markets recovered in 2009–2013, those who'd sold were sitting in cash earning 0%, watching the gains they'd missed.
Decision 3: Over-concentrating after gains
In 2017, after years of tech gains, perception of tech risk was near zero. Investors over-allocated to tech (80% of some portfolios). This was recency bias: tech had outperformed recently, so it felt safe. But concentration in any sector is inherently risky.
When tech crashed 35% in 2022, those concentrated portfolios suffered dramatically. The risk was always there; recent gains had masked it.
Decision 4: Abandoning a sound plan
In 2022, after seeing bonds fall 15%, investors wanted to "fix" the 60/40 portfolio by going 100% stocks. This decision was driven entirely by recent perception, not by sound analysis. A 60/40 portfolio that fails because of one bad year for bonds is not fundamentally broken—it was the portfolio before 2022, and it will be the portfolio after 2024.
But recency bias makes it feel broken, and investors abandon it at precisely the wrong time (after losses, when they should be rebalancing into the weakened asset class).
The antidote: mechanical discipline
The best defense against recency bias is removing emotion from allocation decisions:
1. Set an allocation based on capacity, need, and willingness (done once, thoughtfully).
Example: 60/40 stocks/bonds, because your time horizon allows it, your need requires it, and your sleep-at-night test approves it.
2. Document the decision and the reasoning.
Write down: "I chose 60/40 because I have a 20-year horizon, need 5% returns, and can tolerate 18% drawdowns. I will hold this allocation regardless of recent returns."
3. Rebalance mechanically, regardless of perception.
Every year (or quarterly), check the allocation. If stocks have appreciated and now represent 65% instead of 60%, sell some stocks and buy bonds to return to 60/40. Do this even if equities feel "safe" (perception bias would tempt you to hold the higher equity allocation).
If bonds have fallen and now represent 35% instead of 40%, buy more bonds (at a discount) to return to 40%. Do this even if bonds feel "risky" (perception bias would tempt you to reduce the lower bond allocation further).
4. Ignore news and sentiment.
The financial media's job is to create urgency and emotion. Ignore headlines about "Is bonds dead?" or "Is stocks overvalued?" Your allocation doesn't change based on this month's narrative.
5. Let rebalancing be your contrarian action.
The mechanical discipline of rebalancing naturally forces you to buy low (after crashes, when perception is bleakest) and sell high (after gains, when perception is rosiest). This is the opposite of recency bias, and it works.
The historical record of mechanical rebalancing
Data from Morningstar, Vanguard, and others show:
A 60/40 portfolio rebalanced annually outperforms:
- A 60/40 portfolio with no rebalancing by 0.3–0.5% annually (small but compounding to 10–15% over 30 years)
- A 70/30 portfolio that drifts with recent returns (no rebalancing) by 1–2% annually
Why? Because rebalancing forces you to systematically buy the underperforming asset and sell the outperforming asset. Over decades, this slightly improves returns and dramatically reduces risk (because you're not drifting toward extreme concentrations).
The investor who rebalanced in 2009 (buying stocks at the bottom, when perceived risk was highest) earned the recovery. The investor who didn't rebalance and drifted toward bonds missed it.
Recency bias in your own behaviour
Ask yourself:
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Am I considering changing my allocation because of something that happened in the last 12 months? If yes, recency bias is at work.
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Would I have made this change decision if that recent event hadn't happened? If no, recency bias is driving the decision.
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Is the change based on my time horizon, need, or capacity changing (i.e., a fundamental change)? Or is it based on recent returns (i.e., recency bias)?
If recency bias is present, do not make the change. Instead, document the impulse and revisit your allocation plan one year later.
The flowchart: resisting recency bias
Related concepts
Next
We've now covered the full landscape of time horizon and risk tolerance: what they are, how to measure them, why they matter, and the psychological biases that lead to bad decisions. The next chapter takes what we've learned here and applies it to building an actual portfolio. How do these principles translate into an allocation you can actually implement?