Swedroe: Avoid The Recency Pitfall

Last year, U.S. real estate investment trusts (REITs) were the best-performing equity asset class. In addition, U.S. stocks far outperformed international stocks. Unfortunately, historical evidence demonstrates that individual investors tend to be performance chasers. They watch the markets, then buy yesterday’s winners (after the great performance) and sell yesterday’s losers (after the loss has already been incurred).

Thus, I wasn’t surprised at the amount of time I spent in 2014, and in early 2015, trying to convince investors to avoid the mistake I refer to as “recency.” Recency is the tendency to extrapolate recent returns far into the future, which causes investors to buy high and sell low. That’s not exactly a recipe for investment success.

The Importance Of Rebalancing

The message I delivered to investors was to stay the course, and even to rebalance as required for them to adhere to their investment policy statement. Rebalancing calls for the sale of some of a portfolio’s recent winners. The proceeds are then used to buy more of the recent underperformers.

Rebalancing will lead investors in precisely the opposite direction of performance chasing, which is what causes investors to underperform the very mutual funds in which they invest.

What far too many investors fail to understand is that a good (poor) return in one year doesn’t predict a good (poor) return the following year. In fact, great returns actually lower future expected returns, and below-average returns raise future expected returns.

Thus, the prudent strategy for investors is to act like a postage stamp. The lowly postage stamp does only one thing, but it does it exceedingly well—it adheres to its letter until it reaches its destination. Similarly, investors should adhere to their investment plans (asset allocation).

Adhering to one’s plan doesn’t mean just buying and holding. It means buying, holding and rebalancing—the process of restoring your portfolio’s asset allocation to the plan’s targeted levels.

In terms of returns, the first four months of this year resulted in the world being turned upside down, at least relative to 2014. U.S. REITs went from the best-performing asset class to the worst performer, and international developed markets and emerging markets far outperformed the U.S.

Simple, But Hard To Do

Using passively managed asset class funds from Dimensional Fund Advisors (DFA), the table below compares the returns that various asset classes earned in 2014 with the returns those same asset classes posted in the first four months of 2015. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios

While the winning investment strategy is simple—employ low-cost and passively managed funds, build a globally diversified portfolio and stay the course—it’s certainly not easy.

One reason is because individuals pay too much attention to what amounts to nothing more than “noise” created by the financial media. They need investors (viewers) to pay attention, because that’s the winning strategy for them. They want investors to feel like they have to “tune in” to know what’s going to happen next.

Unfortunately, there’s no one who can tell them, because no one can predict the future. That’s why the best strategy is to ignore the noise and stay the course, rebalancing as required by your investment policy statement.

There is another important reason that investing isn’t simple. Emotions (such as greed and envy in bull markets and fear and panic in bear markets) can cause even well-developed financial plans to end up in the trash heap.

Implementing a written, and signed, investment policy statement that includes a rebalancing table (with targeted as well as minimum and maximum allocations) will help serve both as a reminder to ignore the noise of the markets and help you to stay disciplined.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.