How recent experiences sway our decisions ::Business Line

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Last week, I witnessed an accident between two motorbikes on my way to work.

That accident shook me so much that I requested my taxi driver to go slow for the rest of our journey. My reaction is not unusual.

Importantly, however, such behaviour has implications on our financial decisions! How?

Consider this. Many people in the US feared air travel after the 9/11 attack. The fear was not unfounded, after all, two planes had crashed into tall buildings and just as well, other planes could crash into other tall buildings.

So, many people took the road instead of flying because they overestimated more such plane crashes.

Behavioural psychologists term this recency bias. It refers to our tendency to extrapolate recent events into the future. This behaviour has important financial implications as well.

Suppose the year is 2006 and you visit an investment advisor to help you with your investment decisions.

The advisor will most likely ask questions to measure your risk appetite, questions such as “if a stock goes down 15 per cent, will you buy it?”

Now, your answer to such questions will be largely influenced by your experience in the market in the recent past. In 2006, the market was vibrant, if prices declined, it moved up just as quickly! So, your typical answer would be to buy.

BIAS IN INVESTMENTS

Now, fast forward to 2009. If the investment advisor were to ask you the same question, you will dread to invest in equity, having experienced large losses in your portfolio in 2008.

Your response has important implications. The investment advisor will most likely recommend investments in equity and bonds based on your risk appetite.

And your risk appetite is measured by your answers to some questions. But your answers are likely to be biased by the recent events, besides other experiences!

It is not just investments. Recency bias also affects your consumption decisions.

Suppose your flight last week was delayed, throwing your work off schedule. You may prefer to use another airline this week, if you are not a frequent flyer with the former airline.

You recognise, of course, that your preference to switch the airline is based on your expectations that the former airline will delay its flight this week as well.

Suffering from recency bias is not always bad! Sometimes, it helps you prepare for emergencies.

If you were stranded on the highway last week with a flat tyre, you will ensure that your spare tyre is in working condition if you will step into the highway this week.

Recency bias could, however, cause problems for you when it comes to money matters!