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Recency bias is the tendency to overweight the most recent information available to us because that information is fresh in our mind.
If we recently heard about a company doing really well or having trouble, we may over rate that information and ignore everything that happened before. This is what we call recency bias. Ignoring information that’s old and placing too much emphasis on recent information.
Recency bias is also regularly encountered in our day to day life example during the appraisal phase in a company. Employees tend to put in more hours at work just before appraisal and tend to build a positive image in the eyes of their manager, which could lead to managers evaluating employees on their recent performance rather their performance during the entire year.
The recent trend where recency bias is currently playing out is the case of mutual funds. Retail investors are investing huge sums of money in mutual funds based on their recent performance not taking into consideration their long term track record. Investors tend to believe that the recent good performance is an indication of a similar performance in the future.
Recency bias causes traders to base their future trading decisions based on their most recent trades. Traders find out that when they are on a winning or losing streak emotions tend to get the better of them and they tend to take decisions which are against their trading strategy and risk management principles.
A simple example is when a trader is on a losing streak. Even if he has made profit on 24 of his last 30 trades, he will have a distorted view and end up making emotional mistakes – if he has lost the last 6. On the other hand, a trader who has only won on 7 of his last 30 trades will still be happy if the last 5 all went in the right direction -in this case, he is likely to get a sense of overconfidence and not stick to his trading plan resulting in huge losses.
If a view was taken of whether markets were more likely to trend higher or lower based upon the direction of the most recent bar, majority would state that, a chart closing with a rising bar looks like it's going up; a chart terminating with a declining bar looks as though it's in decline.
The above chart is of Nifty, when the markets were closing in the green on a regular basis, many traders were expecting the uptrend to continue and the markets to march higher.
One big negative candlestick formation and the same traders changed their entire view on the markets from bullish to bearish expecting the markets to trend significantly lower from current levels. The above example clearly shows how traders build their view based solely on most recent candlestick formation or latest news that they have obtained thus letting recency bias get the better of them.