Avoid Recency Bias in Stock Trading

First start with definition.

In general, recency bias is the tendency of traders to focus only at the most recent events in his/her trading results while ignoring or disregarding the older, equally important trading results. If this bias is not well-recognized by traders, this will affect traders negatively in decision making.

Recency Bias - Focus on recent event and disregard the bigger picture.

Curtis Faith, in his bestselling book (and my favorite too), Way of the Turtle, mentions:

"A trade that was made yesterday weighs more heavily than do trades from last week or last year. Two months of losing trades can count as much as or more than the six months of winning  trades that happened previously. Thus, the outcome of a series of recent trades will cause most traders to doubt their method and decision-making process."

 Examples of recency bias..

#1. A mechanical trader, who uses technical analysis and candlestick patterns, places a lot of weight on newly formed candles or exponential moving average (which give more weight on recent results), making him lose track of the long-term trends.

#2. A fundamentalist puts too much meaning to recent economic events and fails to take into account the larger macroeconomic background.

#3. Another example related to psychological aspect. Say there are trader A and B, having each 10 trades so far. Trader A is on 3-trade winning streak, with overall record 4 wins and 6 losses. Trader B on the other hand, is on 3-trade losing streak, with record 7 wins and 3 losses. Trader A has 0% return, while trader B is 10% up year-to-date. If both traders are trapped in recency bias, trader A could end up ignoring possible warning signs and enter a trade hastily while trader B could become frustrated, abandon his risk management rules, and start overtrading. Both situations are clearly undesirable.

Solutions..

#1. Keep track of all trades and trade history. This is obviously helpful so that you can always know where you stand and not trapped in recency bias. You do not have to be Excel expert to start making a simple spreadsheet to keep track your performance in the stock market.

#2. Stick to your written plan and system.

#3. Write down mistakes you did. Not following your system is a mistake - write it down. Forgetting to put a stop loss is a mistake - write it down. Pulling out of the market while still profiting is a mistake - write it down. Buying a stock out of excitement (because you are on winning streak) is a mistake - write it down.