Don’t let your natural biases ruin your retirement

To put it succinctly, ‘recency bias’ is the natural human tendency to assume that the future will look a lot like the recent past. It’s a dynamite survival protocol but it can be deadly if it influences your investment decision making. And it’s not just private investors who make this mistake – it’s just as common among professional investors and institutions. Ironically, it’s a tendency that greatly increases the peaks and troughs seen in stock market performance over longer time frames, even though it actually prevents investors from considering the cyclical nature of investment markets when they come to invest.

History lessons

There have been two great examples of this in the last 20 years or so (although it occurs every day). The first occurred in the closing years of the last century when internet stocks were bid up so much that it resulted in the infamous ‘dotcom’ bubble. At the time, recency bias encouraged investors to pile into any internet-related business, regardless of whether it had ever generated a profit. The euphoria for these new companies on the way up was only matched by the despair investors subsequently felt when the bottom fell out of these companies and many lost up to 90% of their face value. The global financial crash of a decade ago was a similar example. The collapse of the US sub-prime mortgage market and the contagion it spread to other parts of the financial market was enough to crash global stock markets as investors around the world pulled out, crystallising their paper losses into real ones. Due to recency bias, investors couldn’t contemplate that the future would look any different from the recent past.

Thanks to the unprecedented actions of central banks around the world, which cut interest rates to all-time lows and started to pump trillions into the financial markets, it took barely three years for major stock markets to recover their former levels.

Since then, western stock markets have continued to rise with the US celebrating its longest ever bull market in August 2018 when the S&P 500 Index clocked up 3,453 days without a major correction. This has led to more market euphoria and made the ‘FAANG’ group of companies – namely Facebook, Apple, Amazon, Netflix and Google (Alphabet) – the most closely watched on Earth.

Survival instincts

Unfortunately, the fact that we’ve evolved to regard recent information as more valuable than older information may be a useful survival mechanism, but it’s a real millstone when it comes to managing your investments – especially those in your pension pot. Indeed, recency bias is the reason that any investment literature you receive will always be stamped with the warning that ‘past performance is not a guide to future returns’.

Add to this a host of other related cognitive biases such as hindsight, anchoring, loss aversion, outcome bias and herding and it’s clear that you need to have a robust and flexible plan for your pension investments if you’re to avoid being sucked into the next great market crash.

This is because how your pension pot behaves in the years immediately before you reach retirement and the first few years after you retire, will have a far greater impact on your prosperity in retirement than all the years when you were carefully saving into your pension pot

The value of investments and the income they produce can fall as well as rise. You may get back less than you invested.

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