Swedroe: Recency Bias Damages Returns

Stick to your plan and don’t get suckered by the latest hot trend.

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.

Beware US Stocks?

For example, according to data from Morningstar, the current price-to-earnings (P/E) ratio for the S&P 500 is 17.3. The P/E for the MSCI EAFE index is 14.8 and the P/E for the MSCI Emerging Markets index is just 12.0. What almost always happens is that recent, hot performance leads investors to rush in just when valuations are high and expected returns are low.

Current valuations have led to a forecast of real returns for MSCI EAFE that are a full 1 percent higher than for the S&P 500 and about 2.7 percent higher than for emerging markets.

So what do you think is the smart thing to do? Is it to sell international equities when their expected returns are now higher and purchase more U.S. equities when their expected returns are now lower? Or is it to rebalance your portfolio, selling U.S. stocks (high) to buy international stocks (low)?

Commodities

We'll now turn our attention to the poor performance of commodities, and the "three-headed monster" that's striking at investors: recency; thinking in isolation; and confusing strategy with outcome.

We'll begin by pointing out that, in general, there are two main reasons for including commodities in a portfolio. The first is to hedge the risks of unexpected inflation, because commodities tend to perform well when inflation is rising and/or is greater than expected. Stocks and especially bonds tend to perform poorly during these times. The second is to protect against the risks of a negative supply shock, such as a disruption in the supply of oil due to war or an embargo. In other words, commodities are considered in a portfolio not to enhance returns, but to dampen volatility and cut "left tail risk."

It shouldn't be surprising to see commodities perform poorly during a period in which realized inflation has generally come in short of expected inflation and inflation expectations overall have moved lower.

In addition, to continue our oil example, due to innovations in fracking technology, we have had a positive, instead of a negative, supply shock. So you shouldn't be at all surprised that your "insurance policy" didn't pay off.

Hindsight bias also comes into play here, leading to the mistake of confusing strategy with outcome. But smart investors know that only fools judge a strategy by the outcome without considering what alternatives could have occurred. For instance, no one would complain about "wasting" the premiums on their life insurance policy if it expired without them collecting on it. Yet so many investors do something similar when it comes to investing.

Recency is certainly also playing a role here.

For example, in 2009 and 2010, the PIMCO Commodity Real Return Strategy Fund (PCRIX) returned 39.9 percent and 24.1 percent, respectively. In those same two years, Vanguard's 500 Index Fund returned 26.4 percent and 14.9 percent, respectively. No one was complaining about the performance of commodities then. Bu, the recent poor returns are once again leading investors to chase performance. A buy-high and sell-low strategy, however, is not exactly a winning one.

The Only Right Way To See Things Is In The Whole

Another mistake investors make involves thinking about commodities in isolation, rather than how their addition impacts the risk and return of the overall portfolio. Since the risks of commodities mix especially well with the risks of nominal bonds (their returns have been negatively correlated), when adding commodities, you should also consider extending duration risk, which earns the term premium.

We'll look at the 10-year period from 2005 through 2014, a time during which the Bloomberg Commodities Total Return Index produced a total return of -17 percent, to see how adding commodities while also extending maturity would have worked.

We'll begin by evaluating four portfolios allocated 60 percent to stocks and 40 percent to bonds, with and without commodities. For the portfolios without commodities, the 60 percent equity allocation will be 36 percent to the S&P 500, 18 percent to the MSCI EAFE index and 6 percent to the MSCI Emerging Markets index.

For the portfolios with commodities, the equity allocation will be 34 percent to the S&P 500, 17 percent to the MSCI EAFE index, 6 percent to the MSCI Emerging Markets index and 3 percent to the Dow Jones UBS Commodities Index.

For the 40 percent bond allocation, we'll use Dimensional Fund Advisors (DFA) Two-Year Global Fixed Income Fund (DFGFX) and Five-Year Global Fixed Income Fund (DFGBX). (Full disclosure: My firm, Buckingham, recommends Dimensional funds in constructing client portfolios.) The commodities allocation is to the PIMCO Commodity Real Return Strategies Fund (PCRIX), which had an annualized return of -0.33 percent.

• Portfolio A: 60/40 with the DFA two-year bond fund without commodities
• Portfolio B: 60/40 with the DFA two-year bond fund with commodities
• Portfolio C: 60/40 with the DFA five-year bond fund without commodities
• Portfolio D: 60/40 with the DFA five-year bond fund with commodities 

When considering portfolios A and B, we see that including commodities, given their poor performance, did lower the annualized return, but only by 0.1 percent.

However, the addition of the commodities also lowered the portfolio's volatility by the same 0.1 percent. The Sharpe ratio also fell by just 0.01 percent. We see a similar impact when looking at portfolios C and D. The addition of PCRIX did lower the portfolio's return, by 0.2 percent, while having no impact on volatility. The Sharpe ratio was 0.01 percent lower.

More Examples

Now let's consider portfolios A and D. If the addition of commodities was combined with a somewhat longer maturity (in this case, an investor could take the risk of longer-maturity bonds because of the hedge that commodities provide) we see that portfolio D had a 0.4 percent higher return, the same standard deviation, and a 0.04 percent higher Sharpe ratio than portfolio A.

The table shows the importance of thinking about a portfolio in its total context. If you wouldn't have extended the maturity of your bond portfolio unless you also had the commodity allocation, comparing portfolio C with portfolio D is not the right way to think about the problem.

This example demonstrates the importance of considering the risk and return of the total portfolio, and not just focusing on the returns of the individual components.

Finally, before jumping into or out of commodities, it's important to remember that they are notorious for going through lengthy periods when they perform poorly and then other periods (sometimes quite brief and other times prolonged) when they do very well. Unfortunately, no one yet knows how to forecast which period will be next.              

Modern financial theory has demonstrated that the vast majority of the risks and returns associated with a portfolio are determined by the asset allocation decision. But in terms of the returns actually earned by investors, the ability to stay the course, adhere to your plan and rebalance as required is more important than the asset allocation itself.

Unfortunately, behavioral mistakes lead to a failure to maintain discipline, which causes investors to end up with portfolio returns that are typically below the returns of the investments themselves.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.