Swedroe: Difficulties Of Discipline

July 30, 2018

Despite the long-term outperformance, the recent underperformance of U.S. small-cap value stocks has led some investors to question the existence of the size and value premiums. History, however, has provided other examples of long periods of underperformance. It’s just that many investors don’t take the advice offered by Spanish philosopher George Santayana: “Those who cannot remember the past are condemned to repeat it.”

Instead, many investors tend to keep repeating the same mistakes while expecting a different outcome. They also continue to ignore Buffett’s wisdom about his favorite time frame being forever.

There’s another thing I’ve learned over the years about individual investor behavior. While many investors see other people’s decisions being the result of temperament, they see their own as the result of objective, rational thought. That leads to cognitive errors, such as recency. Recency is the tendency to overweight recent events/trends and ignore long-term evidence.

This leads investors to buy after periods of strong performance (when valuations are higher and expected returns are now lower) and sell after periods of poor performance (when prices are lower and expected returns are now higher). Buying high and selling low is not exactly the prescription for success. It also is exactly the opposite of what disciplined investors would be doing: rebalancing to maintain their portfolio’s asset allocation. Instead, recency bias can lead investors to abandon even well-thought-out plans.


Over the two decades I’ve been working with investors, financial economists have documented many investment anomalies. But to me, the greatest anomaly of them all is that, while investors idolize Warren Buffett, they not only fail to follow his advice, they often do exactly the opposite, sometimes to their great detriment. As that legendary cartoon character Pogo said, “We’ve met the enemy, and he is us.” That observation led me to author “Think, Act, and Invest Like Warren Buffett.”

Whenever an asset class (or investment strategy, such as momentum, selling volatility insurance, or reinsurance) performs poorly for any extended period (which for many is as short as a year or less), I’m often called in to dissuade investors from committing what I call portfolio suicide (i.e., abandoning a well-thought-out plan). This generally is caused by two mistakes: the aforementioned recency bias and the mistake called “resulting.” Resulting, which I wrote about earlier this year, is the tendency to equate the quality of a decision with the quality of its outcome.

Hedge fund manager and “Fooled by Randomness” author Nassim Nicholas Taleb put it this way: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”

Hopefully, this article and the example it offers will help you avoid the mistakes of recency and resulting. It may also help you ignore the noise of the market, accepting even very long periods of underperformance as the “price” you pay for investing in risky assets in the expectation (but not guarantee) that you will be rewarded with a risk premium.

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

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