Swedroe: Recency Bias Damages Returns

January 28, 2015

One of the more common and costly investing mistakes that individuals tend to make involves the behavior known as "recency," which can be described as the bias toward overweighting recent events or trends, and ignoring long-term evidence.


Recency leads investors to buy after periods of strong performance (high) and sell after periods of poor performance (low). This behavior results in the opposite of what an investor should be doing (rebalancing) to maintain their portfolio's asset allocation.


With that in mind, it shouldn't come as much of a surprise that I've been getting a lot of questions lately from investors as well as advisors about the recent strength of the U.S. dollar and the poor performance of commodities. I thought it would be helpful to share some thoughts on these two subjects. We'll begin by addressing the issue of currency risk.


The Rise Of The Dollar       

Many of the people who now question strategies that call for foreign currency exposure are the very same investors who were worried in 2008 about the risks of the dollar losing its status as the world's reserve currency and collapsing. This situation is a perfect example of just how powerful the effects of recency can be.


From February 2002 to May 2008, the Federal Reserve's trade-weighted value of the U.S. dollar fell from 129.7 to 95.5, a drop of about 26 percent. And investors were worried it would drop much further. It has since risen to 112, but remains well below the level it reached in February 2002.


Currency A Wash

What's also important to understand is that, in the long run, the impact of currency risk on stock returns tends to be a wash in terms of total returns in U.S. dollars. The following example clearly illustrates this point. World War II devastated the British economy. In 1937, the pound was worth about $5. By 1955, it was worth just $2.80. As I write this column, it's worth about $1.51.


How did this collapse in the value of its currency impact the dollar return on U.K. stocks?


We have data on the FTSE All-Share Index going back to February 1955. Given these conditions, you might think that U.K. stocks would have done poorly relative to U.S. stocks. If so, you'd be dead wrong. From February 1955 through December 2014, the FTSE All-Shares Index returned 10.7 percent, actually slightly outperforming the S&P 500 Index, which returned 10.4 percent.


In other words, for U.S. investors, the drop in the pound was offset by U.K. stock prices rising sufficiently in local currency terms to more than compensate for the fall in value.


There are some simple explanations for why this can happen. First, many of the assets held by U.K. companies generate returns in what, to them, are foreign currencies. For example, a U.K. company's U.S. assets will generate returns in U.S. dollars. Second, when a country's currency drops in value, its exports become cheaper (more competitive) and imports that vie with domestic production become more expensive.


In both cases, the profits of domestic companies benefit. Also in this example, the foreign earnings and foreign assets of U.K. companies become more valuable in terms of the pound. Of course, the reverse is now true for U.S. companies, due to the dollar's strength.


The Only Free Lunch

The bottom line is that the benefits of diversification are well known. In fact, diversification is often referred to as the only truly free lunch in investing. Properly done, diversification can allow investors to reduce the risk of their portfolio without reducing expected returns. Despite the obvious benefits, when it comes to focusing internationally, most investors have a strong home-country bias. And the problem of recency is tempting investors to stray from basic, sound investing principles.


Currency risks can dominate in the short term, with the result being that international diversification may appear to fail. But diversification is a long-term strategy.


There's one more important point to cover. The outperformance of U.S. stocks over the past five years has resulted in domestic valuations that are much higher than international valuations. And current valuations are the best predictor of future returns.



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