What’s the deadliest investing mistake? It’s the one you don’t know you’re making right now. As we continue to experience a strong bull market, and continue to see equity valuations rise, it’s more important than ever to make sure that investment decisions are not driven by emotion. This is the first post in a series about some of the common biases or psychological tendencies that affect investors.
We face a lot of challenges when it comes to doing well with investments. Some issues like reducing investment costs apply to every portfolio, all the time, but have a fixed and relatively minor impact on overall returns. Other issues, like deciding how to allocate funds in our portfolio, may only apply at specific times and under specific circumstances, but can have a huge impact on our bottom line. This article highlights one of the enemies of good decision making.
The Enemy—Past Performance Bias
This first installment of the “Outsmarting Yourself” series is going to focus on the dangers of being a “trend chaser.” This is a common tendency we have to constantly think that recent events can help predict future ones.
WHAT ARE THE CHANCES…
In basketball, this way of thinking is sometimes called the “hot hands” phenomenon. Say a player sinks three shots in a row, and then takes a fourth shot. If we could slow down time as this fourth shot flies through the air, and look into the minds of both the athlete and the spectators, we would see something strange. Everyone watching this shot would have a grossly-inflated opinion of the shot’s chances of going in. After all, the player is on a “hot streak,” so the chances have to be really good of making a fourth shot, right? Actually, probability studies show that the chances are almost identical to if the player had missed the previous shot. In other words, the three successful shots in a row have almost no real effect on the fourth shot, but have a huge effect on our perception of that shot.
If you ever play casino games, you’ll see this happen on the roulette table as well. There will be a string of red numbers, and someone will bet on black because “what are the chances of hitting a fifth red?” Well, even with four prior red numbers showing, the “chances” are exactly the same as they always are because past results do not affect the probability of future events. (If you’re interested, every bet in roulette is at least 5.26% in the house’s favor, making it statistically one of the worst casino games to play—try craps if you want a more even game :))
REALLY, WHAT ARE THE CHANCES?
Be honest with yourself and think about whether you’ve ever looked at two similar stocks and compared the historical return graph. Of course we all have. But is that past performance really giving us any valuable information? Not especially.
The same can be said of specific mutual fund managers—studies again show that the mere fact that a manager has performed well in the past has almost no correlation to future performance.
How can this be? In basketball or roulette, the answer is relatively simple and based on pure statistics, but for investments, it can be a little more complicated. For instance, if one stock has performed significantly better than another, it may just be because other investors all thought that stock was a better buy, and drove up the valuation. Another stock, even one that is objectively somewhat weaker, may be a better buy presently because it does not have such an unreasonably high valuation.
Similarly, a mutual fund manager may have several years of really good performance, but it’s almost impossible to tell whether that performance is caused by some superior intellectual ability, or just dumb luck. Even if the manager is smarter than everyone else, the huge new influx of capital that will chase the stellar performance may limit the manager’s ability to pursue some of the smaller deals that allowed the gains in the first place.
There are plenty of tools that can offer significantly more insight into a stock or mutual fund’s likely future performance, so don’t be lazy by relying on past results.
Making Better Decisions
I have had the “past performance bias” on my mind lately, as the market continues to enjoy an extended bull run. Stock valuations are up, and everyone is making money. Everyone thinks they’re an investing rock star because they haven’t lost money in years. But don’t forget how capricious the market is—that’s a dangerous place to be. Will stocks continue to have a great run for several years? Very possibly, which is why I think the reasonable investor should continue to invest, even if the market is likely headed for a downturn.
But don’t lose discipline by chasing prior gains. Take the allocation between stocks and bonds as one example. Stocks have enjoyed nearly a 70% return over the past five years, but bond yields are abysmal. Why invest in bonds at all when they have only returned about 2% annualized over the same time period? Because they’re part of a well-diversified portfolio. So are “alternatives,” such as real estate, some commodities, and collateralized lending.
By continuing to hold these “under performing” investments, you might give up some potential gains in equities if stocks continue to go up, but you also protect yourself from some of the downside. Luckily stocks have not bitten us yet, but they will eventually. The amount you allocate to bonds and alternatives has a direct relation to your risk tolerance, which has a direct relation to your time horizon. I recommend using one of the many available online risk-tolerance calculators (including the excellent one at Personal Capital) as a starting point to figure out what proportion of your portfolio should chase the prior trends of great stock gains, and what proportion should go to the current dogs (i.e., bonds and alternatives).
In an effort to combat a bias towards thinking that equities will always provide the best returns, I’ve been buying bonds lately—not a lot, but more than I have over the past few years. I’ve also been investing in alternatives, including Fundrise and Yieldstreet. Why? First and most importantly, because my time horizon is getting shorter. Hopefully my wife and I will reach financial independence in about 5-6 years, which doesn’t give our portfolio a whole lot of time to recover if there was a significant market event in the next few years, and bonds should provide a good amount of stability.
Second (although I don’t ascribe a lot of weight to this), is because I’ve been feeling like equities are getting a little overvalued. I try to be very careful with this type of thinking because it’s only a feeling—no one knows whether the markets will “correct,” or continue to become more highly valued for years. I just feel like it’s a little harder to find really good deals in the stock market right now.
Whatever your risk tolerance, there is always some wiggle room regarding your portfolio’s high-level allocation. If an asset allocation calculator tells you to have 5% in bonds, you have to recognize that it’s only a rough suggestion—it cannot know whether 4%, or 5%, or 15% in bonds will actually produce the best returns for you, because no one knows the future. Benjamin Graham, one of the most successful investors in history and mentor to Warren Buffett, recommends keeping within a 75/25 split between bonds and stocks, with closer to 75% being allocated to bonds when the investor feels stocks are overvalued (and therefore holding only 25% in stocks), and closer to 25% in bonds when stocks become a good deal (allocating a more hefty 75% to stocks). Even Graham’s most aggressive recommendation of a 25% bond position is still a little conservative for me given today’s bond yields (bonds yields were much higher when Graham wrote The Intelligent Investor), but I like his thought process.
Right now I’m comfortable with about a 0% to a 15% bond position in my portfolio. In light of my feelings that continuing to chase stocks with current investments would involve some “past performance” bias, I’m leaning a little more towards a conservative portfolio (whereas previously, my investments were basically as aggressive as possible with almost 100% allocated to stocks and alternatives).
My goal over the next few months is to go from the ultra-aggressive 1.5% bond position I had a few months ago, to approximately a 7-9% bond position. I’ve also increased my alternative investments (primarily through Yieldstreet which should also have little market correlation) by a small percentage. Because I have experienced such explosive gains in my equities over the past few years, I have a lot of unrealized capital gains, which I don’t really want to pay taxes on, so I’m increasing my bond position entirely through new investments in bond ETFs (Schwab’s whole-market bond fund SCHZ, their TIPS bond fund SCHP, and a tax-free municipal bond fund TFI).
Once I’ve built this bond position, if equities take at least a 5% drop, my plan is to sell double that percentage of my total bond holdings and reallocate to stocks. So if stocks drop 10%, I’ll sell approximately 20% of my bonds in order to buy stocks at a relatively better deal.
How are you feeling about the market? Is anyone else shifting towards a slightly more conservative allocation? Let me know in the comments below.