Recency Bias: Why Last Year's Returns Feel Like Next Year's Forecast

After a year in which small-cap funds deliver spectacular returns, they tend to dominate conversations, advertisements, and new investment flows. After a sharp crash, many people avoid equities entirely for a long time, sometimes for years. In both cases, the most recent experience is being treated as the best guide to the future. This tendency is known as recency bias, and it is one of the main reasons why many investors end up buying high and selling low despite intending to do the opposite.

This article explains the psychology behind recency bias, what research has found about how people form expectations of returns, and some practical habits that put recent events into longer context.

Availability: what comes to mind easily feels likely

In their 1974 paper on judgement under uncertainty, Amos Tversky and Daniel Kahneman described the 'availability heuristic': people judge how likely something is by how easily examples come to mind. Recent events are naturally the easiest to recall. A crash you lived through last year is vivid; one from fifteen years ago is an abstract statistic. A friend's recent gains are memorable; the long periods when the same strategy did poorly are not.

Recency bias is closely linked to availability. The latest returns, the latest headlines, and the latest stories from people around us are the ones most easily retrieved, so they carry outsized weight when we imagine what will happen next.

What research found about return expectations

In a 2014 study in the Review of Financial Studies, Robin Greenwood and Andrei Shleifer examined several long-running surveys of investors' expectations about stock market returns in the US. They found that investors' expected returns tended to be high after the market had risen and low after it had fallen; in other words, expectations largely extrapolated recent performance. Strikingly, these survey expectations moved in the opposite direction to many model-based estimates of future returns, which tend to be lower after strong rises when valuations are higher.

A related line of research looks at longer-lasting effects of experience. In a 2011 paper titled 'Depression Babies', Ulrike Malmendier and Stefan Nagel found that people who had lived through periods of poor stock market returns were, later in life, less willing to take stock market risk and less likely to participate in the market, even after controlling for other factors. Personal experience, especially recent and vivid experience, appears to shape risk-taking well beyond what the historical record alone would suggest.

How recency bias shows up for Indian investors

• Choosing mutual funds mainly from 'top performers of the last year' lists, which often change significantly from one year to the next.
• Shifting large amounts into a category, such as small-caps, sectoral funds, or thematic funds, after a strong run, and then being disappointed when the category's leadership rotates.
• Stopping SIPs or avoiding equities altogether after a sharp fall, based on the feeling that the recent decline is the 'new normal'.
• Assuming that because interest rates or gold prices have moved in one direction recently, they will keep moving the same way.
• Treating a stock's strong recent momentum as proof of a durable trend rather than one of several possible explanations.

A worked illustration

Consider two hypothetical investors, each with ₹1,00,000 to invest. Rohan looks at last year's returns, picks the category at the top of the list, and invests everything. When that category has a weak year, he switches to the new top performer. Sana sets a mix of categories based on her goals and rebalances once a year. In any single year, Rohan might do better or worse than Sana. The risk for Rohan is structural: by repeatedly moving into whatever just did well, he tends to buy after strong rises and sell after declines, and he pays switching costs and possibly taxes each time. That pattern does not guarantee a bad outcome, but it stacks the odds against the investor in a way that is hard to see from inside any single decision.

Why recent information is not useless

Recent information is not irrelevant. Markets do respond to new facts, and some research finds that short-term price trends can persist for a while. The issue is weighting. Recency bias means giving the latest data far more weight than the longer record, often to the point of assuming that the recent past is the only relevant past. Good decisions usually combine both: what has just happened and what has happened across many different conditions.

Recency works in both directions

Recency bias is usually discussed in terms of chasing winners, but its quieter form may be more costly for long-term investors: staying away after a bad experience. Someone who started investing just before a sharp fall may conclude that equities are 'not for people like me' and keep money idle for years. The vivid memory of the loss outweighs the much longer record of how markets have behaved across many cycles. Recognising that a single painful episode is one data point, not the whole history, can help put that experience in proportion without dismissing it.

Practical self-checks

• Look at longer and rolling periods. Instead of one-year returns, look at three-, five-, and ten-year rolling returns, which show how often an investment did well or badly across different starting points.
• Ask what the base rate is. Before assuming a recent pattern will continue, ask how often similar patterns have continued historically, not just this time.
• Use the 'opposite year' test. If this category had instead been the worst performer last year, would your assessment of its long-term role in your portfolio change? If not, last year's result should not be driving the decision.
• Decide your asset mix in advance and rebalance on a schedule. A written allocation that you rebalance periodically forces you to trim what recently did well and add to what lagged, which works against recency bias.
• Keep a decision diary. Writing down why you made a choice, and reviewing it later, helps you see whether recent events were driving your thinking.

The takeaway

The most recent chapter is the easiest to remember and the hardest to ignore, which is exactly why it tends to dominate forecasts. Investors who deliberately look at longer histories, base rates, and their own written plan give recent events their proper weight: important information, but not a crystal ball.