Humans tend to use recent experiences as predictors of what will happen in the future. The technical term for this is recency bias, and it’s a reason why many investors aren’t as successful as they could be. Paying too much attention to recent trends – like the excellent performance of the stock market over the past 7+ years – often leads to performance chasing, dangerous asset allocation changes, and other harmful decisions.
The S&P 500 peaked at 1,565 in October 2007, and continued to lose ground over the next 17 months until bottoming out on March 9, 2009. Needless to say, for several years after this 57% loss it wasn’t difficult for me to convince clients to hold an appropriate amount of bonds to help protect against volatility. In fact, during the downturn some clients even questioned why they should hold any stocks at all!
Lately I’ve noticed that I’m spending less time convincing clients to invest in stocks and more time reminding them of the importance of bonds and other unloved asset classes. The pain of the ’07-’09 bear market is starting to wear off, and the horrible performance numbers from the downturn have dropped out of 5-year trailing returns. This means that new investors haven’t experienced anything but a bull market and even experienced investors are forgetting how quickly stocks can drop.
Stocks can be extremely volatile. Although the S&P 500 has averaged a total return of 11% per year since the end of WWII, it hasn’t been a smooth ride! The average intra-year decline for the S&P 500 over that timeframe is around 14%, and there have been six bear markets that sent the market down 30% or more!
One way to help reduce this volatility is to hold several different asset classes in your portfolio in an effort to have investments that “zig” while others “zag.” Unfortunately, maintaining a diversified portfolio isn’t easy for many investors since it involves avoiding investments that have been going up in favor of investments that have been flat or even losing money.
For example, Vanguard 500 Index (VFIAX), a fund that tracks the S&P 500 index of large-cap US stocks, returned 32.33% in 2013. But while stocks of large US companies did great that year, mutual funds and exchange-traded funds (ETFs) that held real estate investment trusts (REITs) barely turned a profit. Using DFA Real Estate Securities (DFREX) as a proxy for the sector, we see that REITs were up only 1.39% in 2013.
During 2013 many investors probably started wondering why they held REITs in their portfolio. But it’s not enough just to avoid selling an asset class that’s flat or losing money. Successful investors continue to buy asset classes when they’re down by investing new money or through normal portfolio rebalancing. (You’ve heard the saying “buy low, sell high” right?)
Oh what a difference a few months make! REITs turned around quickly during the first few months of 2014 with DFA Real Estate Securities earning a return of 31.11% for the year. That’s more than twice the 13.64% return that Vanguard 500 earned during 2014. Investors that were patient enough to keep REITs in their portfolio during 2013 were rewarded, and disciplined investors that continued to buy them through the slump were rewarded handsomely!
Just like it was difficult to buy REITs during 2013, it can be difficult to buy bonds when stocks are outperforming. Even as a professional it’s painful to see my bond positions languish during bull markets and difficult to buy stocks when they’re plummeting!
When making investment decisions it’s important to stick to an allocation strategy that will help you avoid mistakes based on recency bias. Remember that the asset class you hate today could be your favorite in a few months!