Tuesday, February 17, 2015

How Recent Events Hinder Your Return

Investors should be conscious of the recency bias when developing their portfolio. The recency bias is the habit to assume recent trends in market activity will continue well into the future. For example, an investor might have the tendency to overweight large cap stocks in 2015 just because large cap stocks were the big winner in 2014, significantly outperforming small cap and international equities.  This is dangerous because purchasing the asset category that has recently done well is frequently the equivalent of buying something when it is overvalued rather than positioning yourself to benefit from the market’s future movements.

In another example, Tony Robbins recently published a new book titled MONEY Master the Game: 7 Simple Steps to Financial Freedom which falls prey to an increasingly popular version of the recency bias. Mr. Robbins worked with famous hedge fund manager Ray Dalio to create the so-called “All Weather” investment strategy. The asset allocation for the strategy is:

·        30% Stocks
·        40% Long-term Bonds
·        15% Intermediate-Term Bonds
·        7.5% Gold
·        7.5% Commodities

As Mr. Robins points out, the All Weather portfolio has performed quite well during the last 30 years. From 1984 through 2013, this portfolio averaged an annual return of 9.7%, achieved a positive return in 86% of calendar years, and never suffered a loss worse than -3.9% during a calendar year. Not bad!

However, these backdated results create a significant error due to the recency bias. Unfortunately, these investment results reflect only the past 30 years, which happens to represent the strongest bond bull market in history. Assuming bonds will have an equally strong 30-year period going forward is questionable at best and destructive at worst. In fact, as investment analyst Ben Carlson showed, the same All Weather portfolio only returned 5.8% annually during the much longer time period of 1928 to 1983.

Of course, my point is not that Tony Robbins’ book isn’t worthwhile, or that the All Weather portfolio is a poor investment.  In fact, all of Mr. Robbins’ seven steps are sound financial practices, such as learning to invest in your future, keeping investment fees low, setting realistic rate of return goals, diversifying, and creating a retirement plan. Additionally, the All Weather portfolio may actually be an appropriate investment for investors who don’t need much return to achieve their retirement goals and are most interested in minimizing risk.

My point, however, is that we should not let the recency bias skew our expectations for our investment portfolios going forward. It could be catastrophic if an investor assumed they would achieve a 9.7% annual return during retirement utilizing the All Weather portfolio only to have the historic rally in bonds fade out, making that rate of return unachievable. Similarly, it would be equally damaging to assume a loss of more than -3.9% isn’t possible, since examining results before 1983 tells us that this portfolio has lost as much as -17.5% in a calendar year.

The recency bias can cause us to make unproductive modifications to our portfolios based on recent market movements. Further, over-weighting recent investment results and trends can lead to unrealistic expectations for our portfolios’ risk and return levels. These behaviors can be destructive to an investment strategy. Always be aware of our tendency to overweight recent market trends and resist the temptation to let them negatively impact your long-term investment strategy.

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