Behavioral Finance Series

Behavioral finance incorporates elements of psychology to explain the actual behavior of investors and the subsequent effect on markets, in contrast to traditional finance which posits purely rational investors and efficient markets. In a series of posts, we will go over the most common behavioral biases investors fall prey to and put them in the context of history or current. 

After the dramatic market declines in March, many investors expected markets would continue to fall. While the massive amount of uncertainty surely influenced this sentiment, it also reflected in the natural inclination to weigh recent events more heavily. This inclination is called “recency bias”, and simply put, it means that humans favor current events over historic ones when thinking about what may lie ahead. Recency bias is the reason the rapid market recovery after March lows took many investors by surprise. It also suggests that following this most recent period of strong performance, many investors may well expect the equity market to continue to grind higher and reach new highs. 

This bias is also prevalent elsewhere in investing. In particular, investor behavior, as determined through U.S equity mutual fund and ETF flows, show clear signs of recency bias. For example, many investors expect growth to continue to outperform value, U.S. to outperform international, or rates to stay low forever. 

In the below chart, we display the periods of market performance and subsequent fund flows in the following year. There is a clear pattern: money flows into funds that do well the previous year and money flows out of funds that had worse performance over that same time period.   

Investors must therefore ask themselves: how can they avoid recency bias? The first step in correcting any behavioral bias is awareness. From there, it is important to manage information flow, by looking at more data when analyzing performance, keeping the bigger picture in mind and noting the cyclical nature of relative outperformance. It would also be prudent to deepen the decision making process, approaching investments with analysis, data and thoughtful debate.

Of course, just because recency bias may be influencing investor sentiments does not mean that recent trends cannot or will not continue. It does suggest, however, that investors should focus on the long-run and take these lessons to heart. 

Fund flows into top and bottom performing equity funds 

Billions, decile 1 = top 10% ranked funds, decile 10 = bottom 10% ranked funds  

Source: JP Morgan Asset Management, Morningstar Direct.

Methodology: The Whole US equity MF universe all surviving MF & ETFs that invest within US domiciled companies. Performance to Flows – Follows a simple lag methodology. Rank corresponds to the annual rank at year end.  Flows will look at the following year once that rank was established.

For example, the “2019” bar shows 2018 fund performance ranked by decile and the subsequent net flows into these products in 2019.

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