Avoid ‘Sell Everything’

Folks recall the performance of their investments similarly; that is, they remember recent performance with greater clarity. This trait, called “recency bias,” leads them to extrapolate into the future the good or bad they are experiencing in the moment. That skews their expectations — for better or worse — and distorts their view.

So a recent loss in portfolio value can trigger both recency bias and loss aversion, and that can lead to “sell everything” phone calls. In the worst case, this type of fear cycle can wreak havoc if long-term plans are abandoned.

For example, over the 49 years from 1970-2018, large cap U.S. stock has produced positive nominal calendar year returns 80% of the time and generated an average annualized return of 10.21%. If we consider the impact of inflation, large cap U.S. stock had positive real returns 71% of the time and an after-inflation (or real) average annualized return of 6.00%.

By comparison, U.S. cash (as measured by the 90-day Treasury Bill) had a 49-year average annualized return of 4.80% and positive nominal annual returns 100% of the time. But, after factoring out the impact of inflation (as measured by the CPI) the average real return was 0.80% and real annual returns that were positive only 57% of the time.

More importantly, let’s consider the performance of the two portfolios. First, the seven-asset portfolio had positive nominal returns 86% of the time and a 49-year average annualized return of 9.48%. After inflation is factored out, the average annualized real return has been 5.30% with positive real returns 73% of the time. The 60/40 portfolio had positive nominal calendar year returns 80% of the time and a 49-year return that was 5 bps lower at 9.43%. After inflation, the 60/40 portfolio had positive returns 71% of the time and a real return of 5.25%. This information puts performance over nearly five decades into perspective.

There is a key observation that should not be obscured by so much data: Each index had positive calendar year returns more than 68% of the time,

There is a key observation that should not be obscured by so much data: Each index (i.e., asset class) that we are evaluating had positive calendar year returns more than 68% of the time (based on nominal returns) and at least 57% of the time if using “real” inflation-adjusted returns. More importantly, the two portfolios we are evaluating had positive calendar year real returns at least 71% of the time.

Having a clear understanding of long-term asset class performance (as demonstrated in “Big Picture”) can minimize the potentially negative impact of recent bias during and after periods of market volatility — particularly when the volatility results in portfolio decreases. The reality is that a broadly diversified portfolio will generate positive nominal returns nearly 90% of the time over time measured in decades, not months. Of course, a person who only invests in a diversified portfolio for two years should not expect positive returns in 90% of the 24 months. Even a diversified portfolio can experience two consecutive negative calendar year returns, such as in 2001 and 2002.

In summary, the impressive performances of the asset classes and portfolios in this study are over a 49-year period. Said differently, long-term results take a long time to replicate. The key to achieving long-term results is to stay in the saddle for a long time. The challenge is our natural instinct to avoid losses (loss aversion) and our tendency to over-emphasize what we have experienced most recently.

PQS

 

 

 

 

 

 

 

 

“Securities offered through BB Graham & Co. a Registered Broker/Dealer, member FINRA/SIPC. Principal Planning Service Inc. is not affiliated with BB Graham & Co.”