Why Last Year Feels Like Next Year in Investing

Imagine opening an investment statement at the end of a remarkable calendar year. Over the previous twelve months, a category of equity funds—perhaps small-cap funds or a specific sector fund—delivered a gain of 42%.

The number on the page does not feel like an unusual stroke of good fortune. To the human brain, it feels like the current temperature of the room. It feels durable, normal, and repeatable.

Now reverse the image. Think back to a period when markets fell sharply over six consecutive months, such as early 2020, or drifted sideways with negative returns for two full years. In those months, the prevailing sensation was not that assets had become cheaper. The sensation was that the decline was permanent and that putting money into equities was an act of deliberate waste.

Both reactions spring from the same cognitive habit: recency bias.

The mental shortcut that tricks memory

Recency bias is the psychological tendency to give disproportionate weight to recent experiences when imagining the future. It is not a flaw unique to finance. If it has rained every afternoon for the past week, people leave the house carrying an umbrella even if the morning sky is clear. For most daily survival tasks, assuming that tomorrow will resemble yesterday is an efficient mental shortcut.

Financial markets, however, do not operate like weather patterns within a single season.

When an asset class produces exceptional returns over a short period, several forces are usually at work at once. Corporate earnings may have expanded, interest rates may have dropped, or global liquidity may have surged. Most importantly, valuations—the price investors are willing to pay for each rupee of underlying business profit—often stretch upward.

Yet the human memory tends to discard the underlying mechanics and remember only the outcome. When people look at a recent 35% return, they do not naturally ask whether the underlying companies grew their earnings by 35%, or whether the market simply became more expensive. They register only the sensation that making money was easy, and they project that pace indefinitely into the future.

In psychology, this combines recency bias with the availability heuristic: the easier it is to recall an example of something happening, the more probable we believe it is to happen again.

How this looks in rupees and percentages

To see how this tendency shapes actual outcomes, consider a simple, hypothetical illustration. The numbers here are purely for explanation and do not represent any real investment, past or future.

Suppose an investor has ₹10,00,000 in savings. Over the past twelve months, Category A (a volatile, high-growth equity category) rose by 40%. Over that same year, Category B (a diversified, conservative allocation) grew by a modest 8%.

Under the influence of recency bias, the investor looks at Category A and assumes that its momentum reflects superior quality. The 40% gain feels like the "new normal." Category B looks sluggish, perhaps even incompetent by comparison.

Driven by that impression, the investor moves the entire ₹10,00,000 into Category A at the start of Year Two.

Now consider what happens if the natural cycle of markets asserts itself:

• Year Two: Category A, having become expensive, undergoes a correction and falls by 20%. The ₹10,00,000 becomes ₹8,00,000.
• Year Three: Category A remains flat, delivering 0%. The portfolio stays at ₹8,00,000.

Over the two years following the initial decision, the ₹10,00,000 investment suffered an absolute loss of ₹2,00,000.

Meanwhile, Category B continued at a steady, boring pace, earning 8% in Year Two and 8% in Year Three (purely an assumption for this comparison). The ₹10,00,000 left in Category B would have grown to approximately ₹11,66,400.

The trap was not that Category A was an inherently bad investment. The trap was the assumption that the preceding year's 40% return was a baseline for what lay ahead, rather than an extraordinary surge that had borrowed returns from the future.

The three places recency bias appears most often

In everyday Indian investing, recency bias rarely announces itself by name. Instead, it shows up in three predictable patterns of behaviour.

1. Chasing the top of the return table

Every year, mutual fund fact sheets and financial websites publish rankings of the best-performing funds over the previous one, three, and five years. The schemes at the very top of a one-year table often reached that position by taking concentrated exposure to whichever sector or market segment had an exceptional run.

Investors influenced by recency bias regularly allocate new money to whatever sits at the top of that list. By the time a fund reaches the top of a trailing twelve-month table, the trend that drove it there is often mature. The new money arrives precisely when risk is elevated, rather than when the assets were underpriced.

2. Abandoning disciplined contributions during flat markets

A Systematic Investment Plan (SIP) works mathematically by buying more mutual fund units when prices are low and fewer units when prices are high. This mechanism requires time and patience through stagnant or falling markets to build a low average purchase price.

Yet when an equity fund spends eighteen months producing zero or negative returns, recency bias leads many people to conclude that "SIPs no longer work." The instinct is to pause or stop the contribution. What is actually happening is that units are available at cheaper valuations; what the human brain perceives is an instrument that has failed to deliver.

3. Fleeing to fixed income at market bottoms

When equity markets fall sharply—as they do periodically in every economic cycle—the recent pain is vivid and intense. At that exact moment, bank fixed deposits offering a guaranteed 7% or 7.5% look immensely comforting.

Recency bias leads people to reallocate from fallen equities into fixed deposits after a crash. In doing so, they lock in the paper losses they have experienced and miss the subsequent recovery, simply because the feeling of the recent decline overpowered any historical awareness of market recoveries.

What recency bias conceals about market cycles

What recency bias obscures is a fundamental property of open markets: mean reversion.

Mean reversion is the tendency for extreme performance—both exceptionally good and exceptionally bad—to eventually pull back toward a long-term historical average. A sector that outpaces the broader economy by an enormous margin eventually attracts competition, experiences higher valuations, and cools down. An asset class that has been ignored or punished for years eventually becomes cheap enough that even modest business improvements produce strong subsequent returns.

Mean reversion does not happen on a fixed timetable. An expensive market can stay expensive for months or years. A depressed market can stay depressed far longer than seems reasonable. Because the timing is unpredictable, human beings routinely give up on the concept of cycles and decide that the current condition is permanent.

Understanding recency bias does not mean attempting to predict when the tide will turn. Markets are unpredictable, and attempting to time the exact moment a cycle reverses carries substantial risk of loss.

Instead, recognizing recency bias changes how an investor interprets information. When a return looks spectacular over the past twelve months, the informed reader sees an asset that has already had a powerful run, accompanied by the risks that come with higher prices. When a return looks dreary, the informed reader sees an asset undergoing a down-cycle, rather than an asset permanently broken.

The past year of returns is historical fact. It is a record of transactions that have already settled. It is not, and has never been, a preview of next year.