Before 2008 set a new benchmark for difficult years in the investment advisory business, I used to say that 1998 was my most difficult year in the business. The S&P 500 returned 28.58% in 1998, on the heels of 33.36%, 22.96%, and 37.58% for 1997, 1996, and 1995, respectively. One might wonder how such a robust market makes for a difficult period. My discomfort was solely the result of investor psychology and the specific discontent expressed by clients as a result of their “recency bias” or the underweighting of historical information and overweighting of more recent information/experiences.
In his bestselling book, Thinking Fast and Slow, Nobel Laureate Daniel Kahneman states: “[w]e are prone to overestimate how much we understand about the world and to underestimate the role of chance in events. Overconfidence is fed by the illusory certainty of hindsight.” Here, history repeats itself as investors attempt to drive forward while looking in the rearview mirror, certain that they either made the wrong decisions by not investing in the proper mix of assets or—worse yet—confirming that their dedicated mix of predominantly one asset class was surely the proper choice.
In 1998, the question was simply why not have more in stocks? Post 2011, the question is the same, substituting bonds for stocks. I can think of no better example of “recency bias” than this question. Examining the trailing five year numbers, bonds have outperformed stocks dramatically (approximately +6% compared to -2%, depending on the mix of bonds and stocks and their associated index). The periodic table below linked illustrates the near impossibility of selecting the best performing asset class year to year while simultaneously underscoring the benefit of diversification. One need not be right all the time; rather, they simply need to not be wrong by over-committing to a particular asset class.
Periodic Table of Asset Class Returns
Moreover, it is important to understand the impact of time on one’s thought process. Like a child asking “are we there yet?” on a multi-hour car ride, investors lack the patience to examine the simple facts of regression-to-the-mean and capital markets. Simply said, over a long duration, stocks should outperform bonds and bonds should outperform cash; otherwise our best bet for survival may be to purchase cans of soup and bullets, as our capital market system will have collapsed on itself.
Children simply cannot understand that, as a percentage of their life span, an hour is a much greater figure than the same hour in an adults’ life. Along the same lines, investors—obsessed with recent performance and beating the markets—cannot seem to focus beyond the last three to five years, while their expected duration for investing is decades, if not generations. History has demonstrated that in almost every 20-year rolling period, stocks have outperformed bonds.
The chart above compares the rolling 20-year returns of the S&P vs. the LT Government Bond Index. The chart shows Bond performance relative to Equity performance over those periods. Bars below the line mean that Equities outperformed (green) and above the line means that Bonds outperformed (tan). The burgundy line is the historical yields for the 10-year U.S. Treasury. Source: Ibbotson Associates
Moreover, regression-to-the-mean should be used to harvest recent outperformance against human nature and apply the laws of what goes up [too much] must come down. Active rebalancing will show that one is likely early to trim from their winners, but ultimately will yield a long-term positive result through reduced volatility.
What does the following chart tell you? Bonds are at the potential apex of a 30-year rally. If history is to repeat itself and bonds regress-to-the-mean, what is next?
Source: Ibbotson Associates
In his book Kahneman introduces a brain devised into two operating systems; he defines a distinction between our actual real world experiences and our remembrances—our imperfect memory—of those experiences. We tend to distort facts, to overweight brief segments, and to ignore the impact of cumulative exposure considerations. Since future decisions will be dependent upon our poor and biased memory of past events, our decisions are likely to be suboptimal and often violate the simple rules of economic and financial theory.
Chaos governs the marketplace. But in a sense, it is an orderly chaos that is partially decipherable and generally predictable. Although the chaos cannot be controlled nor anticipated, its boundaries can be approximated and exploited to a limited extent.
Kahneman advises to integrate the thinking brain with the intuitive brain in all decisions. That utilization of the mind’s full resources helps to anchor any investment decision. By engaging the reflective brain’s inputs we might mitigate the deadly trap of a spurious anchor that wrongly influences our final judgment. In short, let your brain do the work, not your emotions.
This is what we do at Convergent. We use long term statistics to establish a base-rate expected return and guide our clients to stay disciplined. While all humans suffer from emotion, our role is to mitigate the influence of client emotions in making short-term, possibly damaging decisions.
The second half of 2011 started to feel a lot like 1998 as investor sentiment questioned the benefits of global diversification. In the movie Back to the Future, Marty McFly is sent back in time only to be forced to repair the future damaged by his meddling. Similarly, investors should beware the trick their minds can play as a result of heuristic biases that include “it’s different this time.” History has proven time and time again that it will repeat itself.
Patience Is a Virtue
We’ve all heard that patience is a virtue. However, over the past decade it seems like everyone in the investing community has been determined to make short-term and reactionary tactical decisions in an effort to receive instant gratification. In the 1960s, the average holding period for stocks on the NYSE was 100 months compared to present day where it is a mere nine months. Investors now view a strategic long-term plan in the context of a few months instead of years. This thinking is clouded by the recent volatility in the market and the mentality that “this time it’s different.”
From the beginning of October to the end of January, the S&P 500 gained almost 20%. In fact, it was hard to find an area of the market that didn’t produce meaningful positive returns.Those with macro forecasts most certainly did not predict the recent rally we experienced. However, investing is riddled with uncertainty and it is better to invest based on value relative to long-term trends rather than the ever changing macro-economic forecasts. This desire for patience does not simply mean one should sit idly. It means we must be careful and methodical in our approach to allocations and pay strong attention to true value that eventually gets reflected in prices. Investing is a long-term game where patience is one of the key qualities of success.
In January, markets experienced stellar returns. However, they somewhat mask the underlying macro uncertainty continuing to dominate the investing landscape. The U.S. continues its slow expansion and recovery. Economic and political unrest remain in Europe and there are still concerns of its affect on the rest of the world. The attractiveness of stocks over bonds is tempered by the tail risk presented by the European situation. We remain neutral with regard to overall stock exposure, with a tilt towards the United States and beaten-down emerging markets.
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