"Recency" can be described as the tendency to overweight recent events or trends and ignore the long-term evidence. It’s one of the more common and costly behavioral mistakes that individual investors can make, often leading them to buy high and sell low. Clearly, this represents a major problem, as such behavior is exactly opposite of the formula for investing success. My colleague, Kevin Grogan, director of investment analysis at The BAM Alliance, provided me some of his thoughts on how to look at this issue.
A Perilous Pitfall
To start, according to Grogan, many investors place too much emphasis on recent, short-term performance when making investment decisions. The financial media tends to exacerbate the problem, rather than helping investors stick to a disciplined strategy. When evaluating your asset allocation and deciding which fund to use, recent performance should not be a significant factor in your choice. Good strategies will have bad years (or maybe even many bad years in a row).
A current example of this focus on short-term performance involves investors questioning whether or not it still makes sense to own a globally diversified equity portfolio. The argument goes along these lines: The U.S. has outperformed international markets by a wide margin for the last five years, and even if you go back as long as 10 years, U.S. markets are still way ahead of international markets.
The chart below displays the trailing performance of the S&P 500 and the MSCI All Country World ex USA Index (an index that combines both developed non-U.S. markets and emerging markets) through Sept. 30, 2015.
The trouble is that stock returns are extremely noisy from a statistical perspective, so even a period as long as 10 years isn’t extensive enough to make a definitive statement that U.S. equities will outperform international equities going forward. To illustrate this, we’ll take a look at some additional data points.
The chart below reports the trailing performance of the same two indexes we considered before, except that the returns are through Dec. 31, 2009. An investor standing in January 2010 and using past performance to make decisions likely would’ve abandoned their U.S. allocation and shifted into international stocks, right before the U.S. wound up outperforming.