Why the recent past weighs more heavily in your mind than what happened years ago
Recency bias is a specific case of a more general mechanism of human memory: recent information is easier to recall, feels more vivid, and is therefore perceived as more relevant than equally valid but older information, even though there's no logical reason why when something happened should determine its actual importance.
In financial markets, this bias translates into extrapolation: if an asset has risen a lot over the past few months or years, the mind tends to project that same trend into the future, as if the recent past were a reliable guide to what's coming, rather than one specific period among many possible ones.
Morningstar's 'Mind the Gap' studies: chasing past performance is expensive
Financial research firm Morningstar has published an annual study called 'Mind the Gap' for years, comparing the officially reported return of an investment fund with the return actually earned by the average investor in that same fund, weighted by when money flows in and out. The result repeats edition after edition: the average investor earns a lower return than the fund itself, precisely because money floods in after periods of strong recent performance (when the fund has already risen a lot) and flows out after the worst periods.
This pattern is the individual-product counterpart of the same phenomenon we already saw at the market-wide level in the chapter on herd behavior: money systematically chases the return that already happened, not the one still to come.
A historical example: extrapolating a bubble to infinity
during the dot-com bubble of the late 1990s, many individual investors justified valuations of companies with no profits by directly extrapolating the previous years of consecutive gains, assuming the internet had changed the rules of valuation forever. The reasoning wasn't based on analyzing each company's fundamentals, but on the simple observation that the price had been rising for a long time, so it would 'keep rising.'
The outcome, as we explain in our guide to historical speculative bubbles, was the same as in practically every previous bubble: extrapolating the recent trend worked perfectly until the day it stopped working, and it did so far more abruptly than the rise that preceded it.
- An asset rises for months or years in a row.
- The mind extrapolates that trend as if it will continue indefinitely.
- Money floods in right when the trend is statistically closer to reversing than continuing.
Why this bias is so hard to overcome
Part of the strength of recency bias comes from the fact that, in the short run, it often seems to work: buying what has recently risen pays off often enough to reinforce the strategy, the exact same intermittent-reinforcement mechanism that feeds the overconfidence we saw in the previous chapter. The problem isn't that trend-chasing never works, but that statistically it works worse than intuition suggests, and when it fails, it tends to fail suddenly and hard.
How to protect yourself from recency bias
The most effective structural defense is automating your investment contributions on a fixed schedule, rather than deciding how much to invest based on how the market has recently behaved. This eliminates, by design, the temptation to contribute more when everything is rising (right when it's most expensive) and less when everything is falling (right when it's cheapest).
Before investing in any asset because of exceptional recent returns, it's worth explicitly asking: if this asset had had exactly the opposite performance over the same period, would it still look like a good investment based on its fundamentals? If the answer is no, the real appeal probably comes from recency bias, not from analysis.
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Frequently Asked Questions
It's the tendency to give disproportionate weight to the most recent events when making predictions, extrapolating a recent trend as if it will continue indefinitely, even though the recent past has little real predictive power.
That the average investor systematically earns a lower return than the funds they invest in, because money floods in after periods of strong recent performance and flows out after the worst ones.
The evidence shows that recent performance has little predictive power over future performance. Chasing last year's best fund usually means buying right when that trend is statistically closer to reversing than continuing.
Bubbles are partly fueled by extrapolating recent gains into the future, as happened in the dot-com bubble: the longer an asset has been rising, the more people assume it will keep rising, exactly the opposite of what a cold analysis of fundamentals would suggest.
By automating your contributions on a fixed schedule instead of deciding based on recent market behavior, and by asking yourself whether you'd still find an asset attractive if it had performed the opposite way over the same period.