This aerial view shows the Fukushima Daiichi nuclear power plant in Fukushima, northern Japan, on Aug. 24, 2023.The Associated Press
Sam Sivarajan is a speaker, independent wealth management consultant and author of three books on investing and decision-making.
The Fukushima Daiichi nuclear disaster in 2011 was a catastrophic event that highlighted the dangers of ignoring history and building in flood-prone areas. The operator of the Fukushima Daiichi nuclear power plant, Tokyo Electric Power (Tepco), dismissed warnings that the complex was at risk from a tsunami. The plant, despite warnings and historic wave levels, was built for a maximum tsunami height of only 5.7 metres. In March, 2011, the plant was hit by a tsunami wave almost 15 metres high, which led to the meltdown of three reactors.
The warnings Tepco ignored were not just recent ones. In fact, warnings were etched in stone more than a century ago. In the foothills surrounding Aneyoshi, a coastal village in Japan, 19th-century survivors of large tsunamis had engraved warnings into the rocks: “High dwellings are the peace and harmony of our descendants. Remember the calamity of the great tsunamis. Do not build any homes below this point.” Despite these clear warnings, Tepco and other recent residents of coastal Japan built homes and eventually nuclear facilities in these risky locations.
In contrast, the Onagawa nuclear power plant withstood the same earthquake and tsunami despite being located even closer to the epicentre. Its survival was not owing to luck, but to careful planning and preparation. The plant was built at a higher elevation despite the higher cost, and its operators had undergone extensive emergency training, including for a massive tsunami. They were ready to shut it down when disaster struck.
The Fukushima disaster is not an isolated case of societies ignoring historical warnings about natural disasters. A study on the Vltava River in the Czech Republic showed a similar pattern. The study found that extreme floods occur approximately once every 100 to 200 years. Immediately after such a flood, and for two generations afterward, people move back from the river banks and build farther away. However, by the time of the fourth generation after the last flood, memories have faded and people come back closer to the riverbanks, only to invite disaster. When the Vltava burst its banks in 2002, it swamped Prague, causing extensive damage and taking lives.
Many investors also fall victim to memories fading. This recency bias places too much emphasis on recent events and extrapolates them too far into the future. As behavioural economists Denrell and March explain, individuals act as if they underweight the probability of rare events because of a reliance on small samples and the recency effect. The scientists use the analogy of a cat stepping on a hot stove. Based on this one-time experience, the cat won’t go anywhere near a stove in the future – hot or cold.
We see this reliance on small samples every day. For example, the high inflation environment in 2021-22 took many by surprise because they underweighted the experience from the 1970s and 80s and overweighted the low inflation years since 2000.
Similarly, current geopolitical risks were drastically underestimated because of the long period of relative geopolitical stability over the past 30 years.
But why should we care? Because, like Tepco and the residents along the Vltava River, we risk making suboptimal investment decisions, such as panic-selling stocks during short-term market declines or overallocating to asset classes that have recently outperformed.
Keeping a couple of things in mind can help control recency bias. First, look at the long-term data – over multidecade periods, we can see previous cycles and a tendency to correct back to the long-term average. This helps counteract the natural tendency to focus only on the most recent years.
And second, conduct scenario analysis: Evaluate the effects to your portfolio under a range of potential scenarios to understand the spectrum of outcomes. Remember, there are no certainties, only probabilities. Learn to assign probabilities to different possible outcomes. This avoids anchoring only on the recent past.
Implementing these behavioural “nudges” can lead to better investment decisions. We can learn to break free from the recency bias trap. After all, as Mark Twain noted, “History doesn’t repeat itself, but it often rhymes.”
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