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February 27, 2015
Two months past New Year’s Eve and it’s quite likely your own “resolutions” are merely well-intentioned memories. It’s not easy to resist temptation and some might ask why, indeed, they should. Investors may have been tempted, for example, to eschew equities entirely after global stock prices crashed in 2008. However, for those who kept their resolve and their wits about them, they benefited from the past few years, which saw stock prices soaring, eventually rising even past their pre-crash highs.
About this time last year, investors questioned why they should hold onto bonds. Indeed, financial writers insisted that the timing was all wrong for bonds, that the Fed was about ready to rein in stimulus, that bond yields were too low relative to inflation, and that “bond substitutes” were the way forward. In fact, in 2014, interest rates fell and bond prices rose, to nearly everyone’s great surprise, with the Barclays Aggregate Bond Index returning 5.8%. Investors who had succumbed to the temptation of “bond substitutes” were left licking their wounds.
The mistake, or perhaps misconception, of “recency,” as discussed in this post, occurs when investors give greater weight to recent information than the long-term evidence warrants. This, in turn, leads investors to buy after periods of strong performance and sell after periods of poor performance, the diametric opposite of every investor’s mantra, to ”buy low and sell high.” It also results in investors doing the opposite of what they should be doing, namely rebalancing in order to maintain their portfolio’s asset allocation.
This year, even as we acknowledge that both stocks and bonds deserve a place in a well-diversified portfolio, many investors are asking whether some stocks should be avoided. Specifically, they wonder why, in this uncertain global climate, should they be holding onto international stocks. That’s a good question; last year, U.S. investors of international stocks, primarily large companies in Europe and Asia, fell by an average of 6% while emerging market stocks tumbled by 8% on average. At the same time, the S&P 500 Index, driven, of course, by large U.S. companies, returned 13.7%.
The reason for negative returns on the indices wasn’t because those international companies were mismanaged, and it wasn’t due to the threat of deflation. In fact, overall, the performance of those foreign companies was generally strong. The trouble for U.S. investors was currency fluctuations. In “local” currency, some foreign indices returned figures that equaled or even bested the S&P 500, but when the currencies were converted into U.S. Dollars, the almighty greenback walloped its weaker peers.
Of course, currency fluctuations can cut both ways and can boost international stock returns when the U.S. dollar lags other currencies as is happening now. The simple fact is we don’t know where currencies will move next, and a surprise in fundamental data, good or bad, can occur at any time. That surprises can happen is about the only certainty when it comes to any financial market, and that is itself sound rationale for investment diversification.
As Larry Swedroe points out, “Investing in international stocks, while delivering expected returns similar to domestic stocks, provides the benefit of diversifying the economic and political risks of domestic investing. There have been long periods when U.S. stocks performed relatively poorly compared with international stocks.”
Why should investors hold last year’s underperformers? Simply because if you don’t have an underperforming asset class in your portfolio, it most likely means that you’re not well diversified. Going forward, you will tend to be more affected by certain economic downturns than your more diversified peers.
Of course, that’s not to say that diversified investors don’t face risks each year; they do, but they’re often of their own making. Time and again, investors have to persuade themselves to stay the course, within their own disciplined investment strategies, even as friends and neighbors brag about their more concentrated bets. Even positive investment returns can be a disappointment, if they’re less positive than someone else’s. The temptation to judge our own progress by comparing ourselves to others is, of course, simply human nature.
For individual investors, financial goals should be defined in terms of individual timeframes and risk tolerance, not abstract aspirations to “make more” or “do better than” someone else. Investors who cultivate this point of view, resisting the temptation to alter their portfolio allocations based on recent ebbs and flows, are far more likely to reach their long-term goals.
October 24, 2014
Welcome to our final installment in Key Investment Insights. We hope you’ve enjoyed reading our series. Here are the key takeaway messages from each installment:
- Market Prices – Understanding group intelligence and its effect on efficient market pricing is a first step toward better consistency in buying low and selling high in free capital markets.
- News and Market Prices – Rather than trying to react to ever-changing conditions and cut-throat competition, invest your life savings according to factors over which you can expect to have some control.
- The Myth of the Financial Guru – Avoid paying costly, speculative “experts” to pinch-hit your market moves for you. The evidence indicates that their ability to persistently beat the market is “rarer than rare.”
- The Benefits of Diversification – In place of speculative investing, diversification is among your most important allies. Spreading your assets around dampens unnecessary risks while potentially improving overall expected returns.
- Managing the Market’s Risk – All risks are not created equal. Unrewarded “concentrated risks” (picking individual stocks) can and should be avoided through diversification. “Market risk” (holding swaths of the market) is expected to deliver long-term returns. Diversification helps manage the necessary risks involved.
- Smoothing the Investment Ride – Diversification can also smooth the ride through bumpy markets, which helps you stay on track toward your personal goals.
- What Drives Market Returns? – At their essence, market returns are the compensation for providing the financial capital that feeds the human enterprise going on all around us.
- The Essence of Evidence-Based Investing – What separates solid evidence from flakey findings? Evidence-based insights demand scholarly rigor, including an objective outlook, robust peer review and the ability to reproduce similar analyses under varying conditions.
- Factors That Influence Your Evidence-Based Portfolio – Following where robust evidence-based inquiry has taken us so far during the past 60+ years, three key stock market factors (equity, value and small-cap) plus a couple more for bonds (term and credit) have formed a backbone for evidence-based portfolio construction.
- What Has Evidence-Based Investing Done for Me Lately? – Building on our understanding of which market factors seem to matter the most, we continue to heed unfolding evidence on best investment practices.
- The Human Factor in Evidence-Based Investing – The most significant factor for investors may be the human factor. Behavioral finance helps us understand that our own, instinctive reactions to market events can easily trump any other market challenges we face.
- Investors’ Behavioral Biases – Continuing our exploration of behavioral finance, we share a half-dozen deep-seated instincts that can trick you into making significant money-management mistakes. Here, perhaps more than anywhere else, an objective advisor can help you avoid mishaps that your own myopic vision might otherwise miss.
Your (Final!) Takeaway
When we began our series, we promised to skip the technical jargon, replacing it with three key insights for becoming a more confident investor.
- Understand the Evidence. You don’t have to have an advanced degree in financial economics to invest wisely. You need only know and heed the insights available from those who do have advanced degrees in financial economics.
- Embrace Market Efficiencies. You don’t have to be smarter, faster or luckier than the rest of the market. You need only structure your portfolio to play with rather than against the market and its expected returns.
- Manage Your Behavioral Miscues. You don’t have to – and won’t be able to – eliminate every high and low emotion you experience as an investor. You need only be aware of how often your instincts will tempt you off-course, and how you might manage your actions accordingly. (Hint: A professional advisor can add huge value here.)
How have we done in our goal to inform you, without overwhelming you? If we’ve succeeded in bringing our evidence-based investment ideas home for you, we would love to have the opportunity to continue the conversation with you in person.
October 14, 2014
Welcome to the next installment in our series of Key Investment Insights. In our last piece, “The Human Factor in Evidence-Based Investing,” we explored how our deep-seated “fight or flight” instincts can generate an array of behavioral biases that trick us into making what could be significant money-management mistakes. In this installment, we’ll familiarize you with a half-dozen of these more potent biases, and how you can avoid sabotaging your own best-laid investment plans by recognizing the signs of a behavioral booby trap.
Behavioral Bias No. 1: Herd Mentality
Herd mentality is what happens to you when you willingly join the market stampede, despite not knowing whether the herd is hurtling toward a hot buying opportunity or fleeing a widely perceived risk. Either way, following the herd puts you on a dangerous path toward buying high or selling low and incurring unnecessary expenses along the way.
Behavioral Bias No. 2: Recency
Your long-term plans are at risk when you succumb to the tendency to give recent information greater weight than the long-term evidence warrants. We know that, historically, stocks have delivered premium returns over bonds, yet whenever a stock market dips, we typically “see” only recency at play, as droves of safe haven-seeking investors sell their stocks (or vice-versa, when bull markets are on a tear).
Behavioral Bias No. 3: Confirmation Bias
Confirmation bias is the tendency of an investor to favor that evidence which supports his or her beliefs and to dismiss (or even completely ignore) any evidence which refutes it. Of all the behavioral biases, the confirmation bias may be the greatest reason why a rigorous, peer-reviewed approach becomes so critical to objective decision-making. Without that, our mind – so desperately wanting to be right – will “rig” the game for us, even against our best interests as an investor.
Behavioral Bias No. 4: Overconfidence
There are reams of data which suggest that most people (but especially men) believe that their acumen is above average. While overconfidence might be cute in a small child, in investing, it’s not so cute. In fact, it can be outright dangerous; overconfidence tricks us into losing sight of the fact that investors cannot expect to consistently outsmart the collective wisdom of the market.
Behavioral Bias No. 5: Loss Aversion
On the flip side of overconfidence, we may also be endowed with an over-sized dose of loss aversion. That means we have significantly more angst over the thought of losing wealth than excited by the prospect of gaining it. As Jason Zweig of “Your Money and Your Brain” states, “Doing anything – or even thinking about doing anything – that could lead to an inescapable loss is extremely painful.”
For example, investors may prefer to be in cash or bonds during a bear market, or even a bull market when it seems a correction might be due. This is true even though the evidence clearly shows that you could end up with higher long-term returns by buying stocks or, at the very least, by staying put. Yet even the potential for a future loss can be a more compelling emotional stimulus than the likelihood of long-term gains.
Behavioral Bias No. 6: Sunk Costs
As a rule, investors have a difficult time acknowledging defeat. When we buy an investment and it sinks lower, we convince ourselves to hold onto it until we can recoup what we’ve paid. In a data-driven strategy, there is compelling evidence that this sort of sunk-cost logic leads people to throw good money after bad. By refusing to let go of past losses – or even gains that no longer suit your portfolio’s purposes – an otherwise solid investment strategy becomes clouded by emotional choices and debilitating distractions.
So there you have it; six behavioral biases, with many more worth exploring in Zweig’s and others’ books on behavioral finance. We hope you will take the time to learn more, because it can help you become a more confident investor. However, even if you are aware of potential behavioral stumbling blocks, it can still be devilishly difficult to avoid tripping on them. This is why we suggest working with an objective investment advisor to help you see and avoid a collision.
In the next and final installment of Key Investment Insights, we look forward to tying together the insights shared throughout the series.