Key Takeaways
We have a tendency to place too much emphasis on experiences that are freshest in our memory—even if they are not the most relevant.
If you believe markets are efficient, you should expect a significant correction every few years. It’s how markets replenish themselves for future growth.
Reallocating allows you to take some risk off the table and build up liquidity.
“My dad always told me to have a short memory, whether things are going good or bad,” -- Carey Price, NHL all-star goaltender
With everything happening in the financial markets and the world at large, I’ve been thinking a lot about “recency bias.” Recency bias is one of the cornerstones of behavioral finance. It’s what causes us to put more emphasis on things that have happened recently (both good and bad) than on things that have happened in the past. Don’t let recency bias cloud your thinking or distract you from your long-term plan.
Trial lawyers leverage the power of recency bias because they know a jury will remember their final closing argument more so than their opening statements. Real estate brokers leverage it too. They show clients the best/most expensive house last on a tour since that’s the one they’re most likely to remember on the drive home.
When filling out our March Madness brackets (check out Ryan's piece), recency bias causes us to overly favor well-known teams that excelled in last year’s tournament over higher-ranked, but lesser-known teams from this year’s tournament.
In investing, recency bias convinces us that a rising market or individual stock will continue to appreciate, or that a declining market or stock is likely to keep falling. This bias often leads us to make emotionally charged choices—decisions that could erode our earning potential by tempting us to hold a stock for too long or pull out too soon. As a result, sitting on cash too long, or not selling an asset after it has performed well, can lead to lagging investment returns.
Too Much Emphasis on Recent Returns
The last thing you want to do with a diversified portfolio is to allow it to drift too far from your target. The years 2019, 2020, and 2021 were great for the U.S. stock market. There were numerous opportunities to sell stock and buy bonds in each of those years, especially in 2020. Reallocating allows you to take some risk off the table and build up liquidity. As part of a rebalance, we can help you raise enough cash to cover taxes as well. This way, you do not feel cash poor and will be in a better financial position to stay invested during good times and bad. Once you understand that volatility is part of investing and once you are clear on your shorter-term goals, you can stop worrying about predicting the future. The only solution is to have a well-diversified portfolio and to control your behavior.
Band Approach
I like to frame this conversation by focusing on asset classes rather than on individual stocks. When you realize it’s impossible to know which individual stock will go up or down tomorrow, you find it easier to stick to your long-term plan. To help with that discipline we put performance “bands” around asset classes. If a position rises or drops more than say, 20% in either direction, we look for buying (or selling) opportunities. By using predefined bands, we’re able to take human emotion out of the decision. Numerous studies have shown that bands are an optimal rebalancing strategy. Since we cannot predict the market’s direction, we need a structured investment process to help clients fulfill their goals. Let’s say you bought a stock or fund at $100 and now it’s trading at $120. That’s a signal that the investment has done very well (+20%) and it’s time to consider selling some of it. On the flip side, if the same asset has dropped to $80, it might be a good signal to buy more shares, until those shares have appreciated to $100, and it has suddenly become a favored asset class.
As the famous Callan chart below shows, there’s no evidence showing that an individual asset class will consistently be a leader this year, just because it was a leader the previous year. That’s recency bias at work.
Real-World Example
Back in 2020, one of our clients, a Fortune 500 executive and his wife, were adding money to their portfolio very consistently. They were well on their way to a comfortable retirement, but when the markets plummeted by over 30% during the early days of COVID, they stopped their strategy cold. Even though they were still 15 years from retirement, they were terrified that the market would continue to melt down and they wouldn’t have enough cash left to retire. Succumbing to recency bias, the couple stopped making regular additional investments to their portfolio. As a result, they missed out on many attractive buying opportunities, not to mention the market nearly doubling over the next two years. Eventually, they learned their lesson. Because they have a ton of extra cash coming in every quarter and are now investing consistently, their portfolio has been able to recover. I’m pleased to say they’ve stayed the course during this current correction and haven’t fretted a single day about their finances.
Conclusion
If you believe markets are efficient, then you should expect a correction every few years like the one we’re going through now. Just like wildfires remove overgrowth from the forest floor, a correction is how the stock market gets rid of extra froth and speculation so it can replenish itself for future growth. Keeping a cool head during a correction is paramount to your success. If anything, you should be looking for buying opportunities now.
If you or someone close to you has concerns about your portfolio’s ability to withstand inflation, recession, and market volatility, contact us at any time to discuss. We’re happy to help.
ROBERT B. DUNN, CFP® is the President and Managing Partner of Novi Wealth