Throughout my thirty years in the investment business, I’ve witnessed investors going through the same experiences year after year. Now, you may have heard that some people have thirty years’ experience and some only have one years’ experience thirty times. The latter may be true if we never learn from our experiences.
Data on investor returns versus market returns shows that investors often forget, in the heat of the moment, what they know. Investing can be a challenge because we are tempted to feel like the most recent circumstances are the new norm. “This time it’s different,” we say. For example, during market swoons we are overwhelmed with negative news about the market and how things are likely to get even worse.
On the other hand, positive returns can affect our emotions in a destructive way too. Each year, some areas of the market outperform others. If a particular market segment (large US, small US, international large, emerging markets, etc.) always has the highest returns, then we shouldn’t bother investing in anything else. Diversification would be pointless. I should, the reasoning goes, just put all my money in whatever had the highest returns. We call this “track record investing.”
The Most Dangerous Periods for American Investors
The most dangerous periods for American investors are when large US stocks have had higher returns than other market segments in the most recent past. This is because we are overly focused on large US Stocks. Major investment firms and mutual fund companies tend to focus on this market segment because price movements and returns are reported daily in the news.
People like investing in the familiar, and so the biggest investment firms fill their portfolios with well-known companies. If the companies we know the best are also going up in value the most, we feel a sense of comfort. We reason that these big companies should have higher returns because they are so big and successful. It works because it sounds good to the lay investor, but once we understand how stock pricing works, they can’t take advantage of us.
This familiarity bias can sometimes come into play with other market segments too, especially if the media sees big gains there in a recent period. For instance, the media couldn’t stop talking about the run-up in technology stocks in the late 90s, reporting gains in the tech-heavy NASDAQ on a daily basis. People felt like, “everybody’s getting rich but me.” They also spent a tremendous amount of broadcast time talking about increased real estate values in the mid-2000s—leading more people to invest in real estate—at the worst time.
The “Aha!” Moment
So what is the “aha!” moment? Let me set it up by an illustration that uses two market segments and a couple periods in recent history: From 1995 through 1999, the S&P 500 returned 28.56% per year. The MSCI World ExUSA Small Cap Index (an index of small international stocks) went DOWN .36% per year over that period. An investor looking at the trend would have heard about how pointless it was to invest outside the US.
The US had cracked the code on economic growth with technology we thought, and that was certainly the wave of the future.
As investors, we complete patterns in our minds. We think, like in physics, that an object in motion will stay in motion.
But then the reality check came. Over the next five years, the S&P 500 dropped in value by 11%, while the small international stocks in question went up over 200%. Like in physics, what goes up usually comes down.
At this point, seeing how international outperformed US over the past five years, we might ditch large US stocks from our portfolio. The next five years, however, saw US stocks up 8.49% per year, while small international stocks were treading water at a meager .14% return per year. We can’t base our decisions on the most recent past.
Should We Ditch the Losers of the Past?
Here is the “aha!” moment: I was talking to a friend of mine recently and I said, “From the above scenario—looking at the past five years—it would be easy to conclude that small international companies just don’t have what it takes, and their returns will be low going forward. We can look at stock returns as the price that we require others to pay us to use our money. Therefore, to write-off small international companies is to say that they have a free pass on our money. They’re not required to pay us anything from here on out.”
But this doesn’t meet the logic test.
If an area of the market has had little return in the recent past, why would we be willing to take the risk of investing in it for little or no reward? We wouldn’t! In fact, since they are riskier, I might require more return.
Now, since we can’t predict market direction, we can’t actually say whether or not they will have no return going forward, but this understanding helps investors see how illogical it is to move away from yesterday’s losers, and toward the winners.
Why isn’t this common knowledge? Marketing.
Since mutual fund companies, brokerage firms and investment salespeople are in the business of getting you to take action by investing in their products, the path of least resistance is to use your instincts and emotions against you.
When it comes to the investment salespeople, I don’t necessarily believe this is always intentional. Investment people are often poorly trained in the academic principles of investing, but well trained in getting people to invest in their products. This is why I believe the investor must be engaged in the process, and make sure they are comfortable with what they are doing, why they’re doing it, and know what the expectations are. Nobody cares more about your money than you.
Written by Paul Winkler
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