Investors and traders often suffer from behavioral biases, which is where behavioral finance originates. Among these biases, recency bias is probably the most detrimental, yet it has infrequently been studied in a comprehensive, quantitative manner.
Reference [1] addresses this gap by investigating recency bias in stocks with high idiosyncratic volatility (IVOL). The authors hypothesize that investors excessively extrapolate recent changes in volatility, particularly when high-IVOL stocks have become more volatile in recent periods relative to earlier ones, and they propose using changes in IVOL as a measure of recency bias.
The paper further develops a trading strategy to exploit this bias by buying low-IVOL stocks with declining volatility and short-selling high-IVOL stocks with increasing volatility. The authors pointed out,
We bring in the role of investors’ excess extrapolation associated with the recency bias as an explanation of the IVOL anomaly. We hypothesize that investors have higher tendency to excessively extrapolate past return volatilities of high IVOL stocks whose returns became more volatile in recent periods. The extrapolation bias accelerates investors’ preference for such stocks and further enhance the magnitude of overvaluation.
Accordingly, we form a recency-enhanced IVOL strategy to capture investors’ excess extrapolation to emphasize more on recent IVOL. We show that it generates significant and robust profitability. The other components of the standard IVOL strategy, which is referred to as the non-recency IVOL strategy, is mostly unprofitable. An implication to practitioners is that considering the recency effect is important when trading against idiosyncratic volatility. Our study also adds to the vast literature on the understanding of the IVOL anomaly. The implication to future studies examining the anomaly is that the role of recency biases should be considered when examining overvaluation of high IVOL stocks.
In short, the paper attributes the IVOL anomaly to investors’ recency bias, and by incorporating this recency effect, a recency-enhanced IVOL strategy yields significant profitability.
This is an important topic, with implications not only for stocks and volatilities but also for trading strategies themselves, as traders often abandon sound strategies due to recent poor performance. Further research in this area would be highly valuable.
Let us know what you think in the comments below or in the discussion forum.
References
[1] Wen-Chi Lo, Kuan-Cheng Ko, Recency biases and the idiosyncratic volatility puzzle, Finance Research Letters, Volume 91, March 2026, 109468
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