February 7, 2018

Recency Bias: More Relevant in Today’s Context

Joydeep Sen

WiseInvestor

Recency Bias: More Relevant in Today’s Context

In behavioral finance, there is a concept of recency bias, which means a preference for, or expectation of, what happened in the recent past to re-occur, rather than expecting what is more likely to happen realistically. To give an analogy, if a drive on the road has been smooth so far, people expect the road ahead to be smooth and are surprised if there are potholes ahead, and vice versa.

What is the relevance of this analogy?

For almost last 9 years, the market has been on a bull run, apart from some corrections in between. From a bottom of less than 9,000 in February 2009, Sensex is at more than 34,000 now even after the correction post-Budget. There were a couple of corrections in between; From December 2010 to December 2011 (from approx 20,500 to approx 15,500) and from February 2015 to February 2016 (from approx 29,400 to approx 23,000). By virtue of this positive run from 2009 till date, people have started forgetting volatility risk in investments. The last major correction has become the distant memory now, the one that happened from January 2008 to February 2009, when the Sensex corrected from more than 20,000 to less than 9,000.

Please don’t get me wrong. I am not calling the market, I am not talking about a major correction ahead. All I am saying is, we are in a situation where bond prices are dipping – 10-year yield has moved from 6.4% in July 2017 to 7.6% now and equity market is climbing new heights, at least up to the Budget day. This is creating a ‘recency bias’ that equity markets cannot correct and the bond market is more volatile. This is leading to complacency. To give the analogy of our cricket team, if the team wins three consecutive matches and loses the fourth one, we say they are ‘suffering from complacency’. In the context of markets, in the current situation, some people are suffering from this complacency, that equity markets are less volatile than debt markets. Historically, and by the nature of market behavior, the equity market is more volatile. Investors shifting from debt to equity because ‘debt is volatile and equity is stable’ is an anomaly.

What does this lead us to?

When we as financial advisers or planners draw up the allocation, it should match the risk appetite of the investor. The recency bias is impacting the risk perception of the two asset classes, thus leading to a probable mismatch in allocation in the portfolio. If the client asks for a higher allocation to equity due to this recency bias we have to modulate it, or at least sensitize the client, on the inherent volatility in the two asset categories. Having said that, the client will ask for the rationale. On equity, it looks like a blue sky scenario as of now, only that valuations are little stretched than earlier.

On debt, it is easier to reason why the market should remain stable in the short to medium term: (a) in the move from 6.4% to 7.6%, lots of negatives have been discounted and that is not expected to have an incremental impact on the market (b) the RBI is not expected to hike rates, at least in the foreseeable future, as GDP growth is yet to pick up meaningfully and real interest rates are still reasonably positive and (c) the Government intends to contain fiscal deficit to the extent possible, barring the minor slippage announced in the Budget.

One approach that has caught fancy over the last year or so, in conjunction with the bull-run in the industry, is to allocate to Balanced Funds. The logic is, it provides 65% or higher participation in equity market upside, while at the same time provides some stability by virtue of approx 30% exposure to debt. There is another sub-category of funds within Balanced Funds, which go short on equity to a certain extent of the portfolio so that the net exposure to equity is lower to that extent. It is done as per the fund manager’s reading of valuations of the equity market.

Since the Mutual Fund industry is going through rationalization of Funds as per SEBI guidelines on categorization and de-duplication, as and when the restructuring is complete, we will be in a better position to gauge Balanced Funds. Balanced Funds provide efficiency of equity dividend taxation, provided 65% is maintained in equity. In the new scheme of things, Conservative Balanced Funds will not have the tax efficiency, Aggressive Balanced Funds will have. As and when we get a better perspective on the positioning of Balanced Funds, we can do client asset allocation accordingly.

It is worthwhile to look at Arbitrage Funds in this context, as volatility levels are more like debt than equity, and net of dividend tax efficiency of Equity Funds, it outperforms Liquid Funds. Arbitrage Funds are an efficient vehicle for parking of funds till we get more clarity on restructuring in other categories of funds. Net-net, moderation of recency bias and potential volatility in a portfolio is desirable.