Whilst current news and events tend to capture our attention and can often lead our investment decision making. Yet the truth is, this tendency to focus on recent events can be deeply counterproductive for us as investors. In this edition of Insights, our finance writer, Robin Powell explains why.

Being a sports fan is like riding an emotional rollercoaster. You can go from elation to despair from one match to the next — and I speak from recent bitter experience. The football team I support has been on an excellent run for many months, but then, out of the blue, we lost 4-0 at home to our nearest rivals, and suddenly all looked bleak. I even started to wonder whether we would win again all season. 

The experience of Investing in equities is very similar — or at least it is if you follow the daily ups and downs of the stock market. You can get very excited seeing your portfolio grow as the market rises, and then, just when you were dreaming of buying a new car and or retiring early, stock prices plummet and commentator after commentator warns of worse to come. At times like these, the temptation is to sell your stocks or at least reduce your exposure. 

Behavioural psychologists call this phenomenon the recency effect. The term refers to our tendency to give more weight to the most recently presented information than information presented earlier. Other examples are the way that people stop flying after a plane crash or take out earthquake insurance immediately after an earthquake. 

It’s perfectly natural that we display these behaviours. It’s the way our minds, and particularly our memories, have evolved. For early humans, recent observations about weather conditions, predator movement or the availability of resources were crucial for survival. The recency effect would help to prioritise this fresh, and potentially critical, information. 

The problem is that, when it comes to investing, our tendency to focus on recent events and what’s happening right now can be very unhelpful. Why? Well, the simplest and most reliable way to invest is to have a broadly diversified portfolio and benefit from the miracle of compounding by holding it for a very long time. All the evidence tells us that chopping and changing our portfolio, and jumping in and out of the market, reduces our eventual returns. Recent and current events contract our time horizon and tempt us to act in ways that might give us short-term comfort but which we will probably come to regret. 

What, then, can we do about the recency effect? Here are five suggestions. 

Set your expectations 

If you’re investing for 20 or 30 years or more, you are bound to experience severe market downturns. So, develop an appreciation of financial history and the ebbs and flows of the markets. Prepare yourself mentally now for when those downturns arise. 

Design a comprehensive investment program including a behavioural plan 

Spend some time before you commence investing, thinking about all the elements that contribute to effective portfolio design. What is your investment horizon? Risk capacity? Risk Tolerance? Return Objective? How will you deal with a crash or steep correction? A well devised investment program will inform both portfolio construction and portfolio management.  

When you encounter new and material market news, in almost every case, the best course of action will be to avoid reacting or acting with emotion. If you are well prepared, then you are more likely to stick to your plan – which may involve rebalancing your portfolio to asset allocation benchmarks (i.e. topping up the asset classes that have suffered during the correction and reducing the asset classes that held up ok).  

Ideally, find a financial adviser who can act as a behavioural coach and to whom you can turn if you’re feeling anxious. 

Use portfolio construction to your advantage 

Well diversified portfolios will typically include two distinct components. The first contains more volatile growth assets, principally equities, that can rise and fall significantly from day to day; the second includes more defensive assets such as cash and bonds that tend to be less volatile. Tell yourself that you don’t need to touch the growth part for a long time, and that it doesn’t matter if markets crash because your investments have plenty of time to recover. 

Stop zooming in, start zooming out 

Try to see the bigger picture. At any given time, there are always reasons for investors to be nervous. Similarly, you’ll always find plenty of exciting investment “opportunities” to consider if you go looking. But most of what we read about investing and the financial markets isn’t helpful information we should act on; it is mostly just noise. The key is to refrain from zooming in on tiny details, and instead to zoom out and take the long-term view. 

Ask, will it matter in five years’ time? 

In his bestselling book Thinking, Fast and Slow, the Nobel Prize-winning behavioural expert Daniel Kahneman wrote: “Nothing in life is as important as you think it is, while you are thinking about it.” It’s a really important point to remember whenever you’re tempted to recent or current events. Most investors waste far too much time thinking about things that ultimately don’t matter. Whatever it is you’re worried about today you will almost certainly have forgotten all about it in five years’ time. 

In case you were wondering, after that 4-0 defeat, the team I follow won 4-0 a few days later, and now all the fans are hopeful of a successful end to the season. In sport, as in the markets, the mood can change with breath-taking speed.