The Challenge of Investing After an Abnormal Year

Charlie Bilello
January 7, 2014

One of the most difficult things to do as an investor is avoid overreacting to recent performance. This tendency to project your most recent experience onto the future is best known in behavioral finance as recency bias. Although recency bias can be harmful in many walks of life, it is particularly harmful to investors following an abnormal year in the markets.

With 2013 now in the books, we can only describe it as just that: abnormal. As measured by the Standard & Poor's 500 index, U.S. equities advanced 29.6 percent in 2013, which is their highest return since 1997. Within the S&P 500, 93 percent of stocks finished higher on the year - a record high. These returns were achieved with unusually low volatility, as 2013 marked the first year since 1995 that the S&P 500 did not trade below its 200-day moving average during the entire year.

These facts alone would qualify 2013 as an outlier year, but what makes 2013 truly abnormal is what you find when comparing the performance of U.S. equities to all other asset classes. As U.S. equities closed out the year at new all-time highs, bonds, real estate investment trusts, preferred stocks, gold, commodities and emerging markets were moving in the opposite direction. All of these asset classes finished lower in 2013.

This becomes dangerous for investors when they assume that such a year is likely to be repeated. In making such an assumption, investors are more likely to shift their portfolios out of the asset classes that have performed the worst (everything other than U.S. equities) and into the asset classes that have performed the best (U.S. equities). Historically, chasing recent performance has not been a winning strategy for investors.

Morningstar quantified this fact through 2009 data, comparing the average return of mutual investors to the actual returns of the funds themselves. What they found was that the average investor return in all funds during the period from 2000 to 2009 was 1.68 percent compared with a 3.18 percent return for the mutual funds themselves. The difference in performance was primarily due to poor market timing, with investors consistently chasing the trendiest asset class of the day.

The period from 2007 to 2009 was particularly challenging for investors and illustrates recency bias at its worst. At the end of 2007, investors in U.S.equities had enjoyed five consecutive years of gains and were quite happy to increase their exposure to equities heading into 2008. One year later, after a 37 percent decline in the S&P 500, investors had moved to the other end the spectrum. Money moved out of equity funds in favor of defensive bond funds as talk of a second Great Depression took hold. Of course, at the end of 2009, after a 23.5 percent gain in the S&P 500, depression fears faded and it became clear that investors had been whipsawed once again.

Fast forward to today, and we have a similar setup to the end of 2007, with U.S. equities advancing in each of the past five years and bullish investor sentiment near historic highs. The temptation here is to follow the crowd into U.S. equities with the expectation that we will see a repeat of 2013 this year. Recent data on mutual fund flows suggests that investors are doing just this, with flows into U.S. equity funds at their highest rate since 2000.

Unfortunately, these investors are likely to be disappointed in the years to come if history is any guide. While it is human nature for all of us to suffer from recency bias, there are steps we can take to limit its pernicious effects and become smarter about how we invest:

1. Develop a plan and stick to it. Figure out your goals and create an asset allocation plan best-suited to achieve those goals. Don't let your emotions alter that plan.

2. Don't read too much into short-term performance. You cannot judge a strategy or asset class on a single year's performance. Short-term returns are not indicative of manager skill, and as the disclaimer reads, are certainly not indicative of future results.

3. At the margin, take advantage of valuation and contrarian opportunities. Rebalancing your portfolio after a long rally or sell-off in an asset class can accomplish this. In today's market, such an opportunity may be arising in emerging market equities, which have been underperforming U.S. equities for over three years. This has left emerging markets significantly cheaper on a valuation basis.

4. Evaluate your past decisions. This is something that investors rarely do but is necessary if your goal is to become a better investor. Take a look at your past buys and sells and the subsequent performance. If you see a pattern of selling near the low and buying near the high, you are likely suffering from a bad case of recency bias.

Charlie Bilello is the director of research at Pension Partners, LLC. He is responsible for strategy development, investment research and communicating the firm's investment themes. Prior to joining Pension Partners, he was the managing member of Momentum Global Advisors. Bilello holds a Juris Doctor and Master of Business Administration in finance and accounting from Fordham University and a bachelor's in economics from Binghamton University. He is a chartered market technician and holds the certified public accountant certificate.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, a recommendation regarding any securities transaction or an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

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