‘Recency Bias’ can distort our decision making and judgmental processes, thus reducing their effectiveness.

Recency bias is the tendency for traders and investors to give a greater weight to more recent trade performance, news and information, rather than taking into account older news, information and performance. This leads to distorted perceptions, decisions and judgments, and as such can seriously undermine overall performance sometimes with very negative results.

Here is a simplified example:

A trading method or system involves taking hundreds of trades per year. The hit rate is distributed fairly evenly, with more wins than losses, but with wins typically being three times the size of the average loss.

For example a typical run would look like this:

Win, Loss, Loss, Loss, Win, Loss, Loss, Loss, Loss, Win, Loss, Loss, Loss, Win, Loss, Loss, Win, Loss, Loss, Loss. 

(In summary 15 Losses, and 5 Wins: With wins performing three times better than losses the net effect is zero.)

Now compare it to this run:

Win, Win, Win, Win, Loss, Loss, Win, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss.

(In summary 15 Losses, and 5 Wins: With wins also performing three times better than losses, thus again the net effect is zero.)

Whilst the outcomes of the two run of trades are different, the trader may feel differently about his system or method at the end of the second run. The last 10 trades on the second run were all losses, whereas on the first run there were 3 wins out of 10, thus a fairly even distribution. Whilst this example is quite small the effect may nonetheless make the trader start to question his system or method: Is it still valid? Have the rules changed so much that he should alter the (proven) system or method? Should the trader take the next trade? Should the trader lower the risk level on his next trade? – I hope you can see where I am going on this.

In Curtis Faith’s excellent book, ‘The Way of the Turtle’, there is a great example of this: Faith provides a friend, who has begged him to reveal the secrets of his highly successful trading system, with all the details of the system. However the friend rather unfortunately decides to override the system following a string of losses. The relevant paragraph from the book is as follows:

‘Around February 1999 I (Faith) asked him how he was doing in cocoa since I had noticed that there was a great downward trend. He told me that he did not take the trade because he had lost so much trading cocoa and thought that the trade was too risky’. Curtis noted that prior to the downtrend starting there was a run of 17 losing trades. Collectively these losing trades added up to a loss of nearly $17,000. The subsequent 11 trades, which the trader did not take, contained 4 winning trades and 7 losing trades. The net result of these 11 trades was a profit of around $73,000.

It is worth noting that this ‘recency bias’, also occurs in the way we make many judgments, process information and review news. Investors may shun a share because its recent dividends were poor; however behind the scene the company may have made a significant investment in restructuring and producing new lines which will yield significant future results.

Another effect of recency bias is to alter our state of mind. There is nothing worse than a string of losses to dampen our enthusiasm. It may be that at this point we start to question ourselves and our ability, and that opens the door for self-doubt. Once self-doubt creeps in then we could fall into a viscous circle of doubt and crisis of confidence; we then start expecting poor outcomes, and once this starts happening we then actually then create them.

I would also like to add that though these examples focus on negative recency bias effects. However positive recency bias effects can also throw us out. – In the earlier example, a string of recent wins could have caused the opposite effect, making the trader less cautious and far too overconfident, thus leading them to take too much risk, with eventual disastrous consequences.

So what is happening for us to be affected by recency bias? – Well to one degree this is a natural occurrence, in the real world, recent events are much easier to recall. Our working memory, which is part of our conscious mind used for learning new activities, it has only limited resources, and as such is only able to hold a limited number of ideas and memories at any one time. As such older memories get put to the back of our mind, into our long-term memory: Whilst the storage in long-term memory is infinite, the ability to accurately recall this information and to have it at hand is difficult. Thus we have a much clearer recollection of recent events, and as such we end up with a distorted view of reality.

So what should one do to avoid the effects of ‘recency bias’?

1) Awareness of the problem is always the first step. – But rather like recency bias it-self, any memory you have of this article you are reading now is likely to be lost into your long-term memory before long, and will not easily be recalled. I would suggest make a note of this and other biases (Preferably in a journal), reminding your-self of how it may affect your trading and judgement. – It is essential to re-visit this periodically to remind yourself with regard to this and other biases and how they may affect your judgement.

2) Try and ‘develop a habit’ of tracking the record of your trades, or other relevant data you may be watching. – Here again a journal is highly valuable. – When you do hit an extended run of data or news, try and look back at it in perspective of the bigger picture.

3) Set-up rules, guidelines and criteria for trading and analysis. Check yourself regularly to ensure you are abiding by these criteria. Once again, our old friend the journal is an excellent place to note these rules, guidelines and criteria.

4)) Manage your-self: The more stressed and anxious one is, the more one is likely to veer from common-sense, and good practice. Euphoria, over-confidence, despair, self-doubt, and many other stated all have the ability to throw us off course, and lead us to abandon our usual work mode. Try and make obtaining and maintaining balance and perspective part of who you are and how you work. – Once again maintaining and reviewing a journal is an excellent tool to use as part of this process, along with a healthy life-style, exercise, work/home/social balance, etc.

We are as humans all prone to recency bias, however as traders, we have to ensure that somehow we do not let this affect our ability to perform and make sensible decisions and judgments.