Breaking A Bad Habit
Smoking. Talking with your mouth full. Forgetting to put the seat down. All bad habits. Some will kill you; others will simply make you unpopular. But bad habits in investing are the worst, because they are guaranteed to make you poorer!
One of the most insidious of these habits is known as Recency Bias. It occurs whenever we use our more recent experiences as a basis for expecting a future event. It happens all the time with the stock market. People often forget about market cycles when they invest. Here is an example. The NASDAQ index had these annual returns from 1992 until 1999:
In the first quarter of 2000, investors purchased more shares of NASDAQ Index mutual funds than any previous quarter in history. Can you guess what happened next? Here are the following three years' returns for the NASDAQ Index:
Why in the world would investors gobble up shares of a volatile index that had gone up (almost) nine years in a row and finally spiked to a record setting 85.6% return? That's right -- Recency Bias! They never expected the NASDAQ to do something it hadn't done for almost a decade. They were too focused on the most recent results, and forgot about basic concepts like long term cycles, increased volatility, historically high valuations and other factors that may have tempered their enthusiasm.
The same thing happens in the other direction. During a bear market, when month after month of lower account balances is experienced, investors often lose sight of the big, long term picture, and focus on the immediate past's painful results. Often their reaction is to flee to safety (by selling their stocks/funds) at absolutely the worst time -- when the market has already done its worst and its valuation is extremely low and consequently very attractive for future long term returns. Recency Bias strikes again!
We are currently in an asset class cycle that could allow Recency Bias to once again harm investors who do not focus on the long term. As most of our clients know, Small and Value asset classes historically have outperformed their Large and Growth counterparts. See the numbers below:
Clearly, over the long term, Value and Small have lead the way. However, Small and Value asset classes are not perfect. During weak market periods, Small and Value asset classes often lag Large and Growth. Most weakened stock markets are due to a slowdown in the economy, which affects smaller stocks more than large, and value stocks more than growth.
During the last 5 years, the equity markets have endured two bear markets. Consequently, the 5 year average return of both Small and Value asset classes have underperformed Large and Growth asset classes. However, if you look at the statistics, this is an anomaly.
As you can see above, over rolling time periods of 3 and 5 years, investors can expect Value asset classes to outperform about 2/3's of the time. With longer 10 year rolling periods, it is dramatically higher. Consequently, it is important that investors not get caught up with Recency Bias and decide to sell their Value and Small asset classes and buy Large and Growth simply because they go through a period of relative underperformance.
Modern Portfolio Theory and rebalancing asset classes back to desired risk/reward weightings will maintain your portfolio's consistent tilts toward Small and Value. The discipline of rebalancing will insure that poor decisions based on short term results will never have a chance to become bad habits in your portfolio. You can then focus your attention on all those other bad habits that your family, friends and colleagues would like you to change. Good luck!
The first three months of 2012 enjoyed the best quarterly returns in two years, and were the best returns for a first quarter in 14 years. Interestingly, most domestic asset class returns were bunched together in the low double digits. Unlike the data regarding asset class size and style discussed above, during this short term period, it really didn't matter whether you were in Large or Small, Value or Core/Growth. They all performed within a narrow range of each other.
Internationally, there were greater differences among asset class returns. Small did beat Large, and Value did beat Growth, even in the Emerging Market classes. Interest rates ticked up slightly, and therefore long bonds did lose modest principal. This may or may not be the start of a gradual rising of rates that has been expected for a number of years now. We will probably only know that answer after it takes place. As you know, we reduced the interest rate risk in our clients' income holdings well over a year ago, a move which has and will continue to fare well if interest rates, in fact, start a longer term movement upward.
CNBC's quantitative analyst Gio Moreano recently conveyed that since the 1950's, there have been 13 years in which the S&P 500 has risen more than 8% in the first quarter. In every one of those years, that Index ended the year in positive territory.* In all except one (crash year 1987), the Index did not go below its January 1 price at anytime during the remaining 9 months. Obviously, past performance is no guarantee, but statistically those numbers are impressive. *Yahoo Finance; Q2 Kicks Off: Why the Stock Rally May Still Have Legs. Chris Nichols 4/2/12
The economy appears to be modestly growing in fits and starts. Employment, real estate sales trends, retail sales, corporate earnings and other measures of economic growth are mostly positive but clearly fragile, and any major negative global event could upset the progress being made. As long term investors, we do not allow the day to day "white noise" to distract us from owning diversified portfolios of asset classes each owning hundreds or thousands of individual securities. We will keep the weightings among the equity and income asset classes properly balanced to the risk/reward parameters chosen by our clients. This is vitally important, because as events over the last year (or five) have proven, positive returns occur in bunches, and often at the least expected time.
Both the weather and market returns have started the year much hotter than normal. It will be interesting to see what's in store for the next quarter. Get outside and enjoy the June-like weather in April, and we'll talk again in July and compare the temperature on both fronts.
Frederick F. Kramer IV, JD
Chief Investment Officer
Dixon Hughes Goodman Wealth Advisors LLC