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Chasing Returns: Part Two – Avoiding Recency Bias

Kimberly SterlingWhat is “recency bias”? It comes from the field of Behavioral Economics and represents a tendency for some people to focus solely on “what’s happened lately” when evaluating or judging something.

One example is the annual performance review. Some managers tend to emphasize what an employee did in the last few weeks or months, rather than to place equal weight on their performance for the entire year. This bias is defined as the belief that the most recent trend will be the trend that continues for the future.

It is easy to see how recency bias can be applied to investing. Once again this year, a globally diversified portfolio underperformed the S&P 500 Index. In fact, this has been the case for the past three years. So it is perfectly normal to wonder if this global diversification approach is working.

The graph below (Figure 1) shows the last 10 years: 2006 through 2015. During this time, a globally diversified portfolio (blue line) outperformed the S&P 500 (green line) only 4 of the 10 years. What does the graph tell us?

  • For the first 8 years of this timeframe, the global portfolio and the S&P 500 are neck and neck.
  • In this ten-year period, the S&P 500 is ahead by about 12%, all of that occurring in the past two years.
Growth of $1: Last 10 Years Ending 2015
Figure 1

Keep in mind the US dollar made strong gains over the past two years compared to most global currencies. When the dollar rises, it has a negative impact on foreign investment returns.

It is difficult to quantify the exact overall negative impact of the dollar’s strengthening on foreign stocks. However, given that the US dollar is up cumulatively 14.14% against the Yen (Japan), 26.59% against the Euro, and 67.70% against the Real (Brazil) in these past two years, it shouldn’t be a surprise that there is an underperformance in the international equity markets once valued in US dollars.

Before we let the recent underperformance push us toward a conclusion, let’s step back and look at some objective information.  Below are four more graphs (Figures 2 – 5). Each one compares a globally diversified portfolio (blue line) to the S&P 500 (green line), the Foreign Value Index (purple line) and the Consumer Price Index (red line).

The graph below (Figure 2) looks at the time period from 1970 to 2015. This is 46 years – half of a life-time for most of us.

Visually, it appears the global portfolio never underperformed the others. But it actually did underperform in 19 of the 46 years. There were three consecutive years of underperformance from 1989 to 1991. Then there were six consecutive years of underperformance from 1994 through 1999 – ouch!

Cumulatively, however, the global portfolio beat the other two large indexes by returning about three times as much.

Growth of $1: Starting in 1970
Figure 2

The next graph (Figure 3) covers the time period from 1986 to 2015, or 30 years. Most of us want our portfolio to last at least another 30 years.

Here, during the early time periods, we can see the global portfolio (blue line) mingling with the other two lines. But, from the mid ‘90s to 1999, the S&P 500 (green line) surged ahead. That surge was due to the tech bubble. The S&P 500 was delivering returns ranging from 22% to 38% from 1995 to 1999.

But as soon as the tech bubble crashed in 2000, the global portfolio took off. At the end of that 30 years, the blue line is more than double the Foreign Value Index and about 20% ahead of the S&P 500.

Growth of $1: Last 30 Years Ending 2015
Figure 3

Figure 4 considers the time period from 1996 through 2015. This is the last 20 years. The tech bubble is even more apparent on this graph with the green line moving strongly up from the start. This is that six-year period when the S&P 500 outperformed the global portfolio six years in a row.

When the tech crash hit in 2000, the S&P 500 (green line) suffered three punishing years. In 2001 there was the 9-11 terrorist attack and 2002 (the worst year of the three years) saw the failures of WorldCom and Enron. The global portfolio (blue line) didn’t drop as much during these three years.

By 2002 the blue and green lines are close together. From there on, the globally diversified portfolio stays on top.

We all vividly remember the 2008 downturn. All three lines have a similar steep decline during this time period. There was no escape. By the end of this 20-year period, the global portfolio is once again on top.

Growth of $1: Last 20 Years Ending 2015
Figure 4

The final graph (Figure 5) considers the last 15 years, from 2001 through 2015. All markets started this century down. But the global portfolio suffered the least. And at the end of this 15-year period, it is still on top, despite underperforming the S&P 500 for the past three years. The global portfolio is about 40% ahead of the S&P 500.

The first 10 years of this century was called the Lost Decade for the S&P 500 because it didn’t even keep up with the cost of living. To the disappointment of many, that 10 years extended all the way to 2012 before the green line finally poked above the red line.

Someone who stuck with the global portfolio for the entire 21st century (16 years so far) was rewarded with a survivable return of 6.94%. But the S&P 500 has only been able to deliver 4.06%. This may sound like a relatively small difference, but the cumulative impact is huge. Is it any wonder then why the S&P is doing so well currently? It is catching up to its long-term historical average, what financial economists would call “reversion to the mean.”

Growth of $1: Last 15 Years Ending 2015
Figure 5

There may be many reasons for the recent three-year outperformance of the S&P 500 compared to the global portfolio.

  • As the world’s leading economy, it makes sense that the US would be the first to recover.
  • The surge in the value of the dollar understates the strength of returns outside the US.
  • The dramatic drop in oil prices is hurting other countries more than the US.
  • Investors sometimes flock to perceived safety in the US when faced with fear and anxiety over sovereign debt problems with small European countries, middle-east conflicts, Ebola, refugees in Europe from Syria and Africa, a struggling China, etc.

Opportunistically, the very things that pushed the US higher for these three years, makes the global market undervalued and thus possibly a good investment.

No one knows, or should promise to know, how long this global underperformance will last. All we have for guidance is the past. But we remain confident that over the long-term, the global portfolio provides the best chance for successful investing.

Don’t give up on the global portfolio. Don’t make the mistake of chasing returns based on the recent best performer. Talk to your advisor if you’d like more details. With practice, it will become easier NOT to second-guess a successful long-term strategy.

Sources:  Dimensional Fund Advisors, Inc. (DFA). US Large – Standard & Poor’s 500®. US Large Value – Fama-French Large Value Research Index (1970-2013) Russell1000 Value 2014-2015. US Small – Fama-French Small Cap Index (1970-2013) Russell2000 2014-2015. US Small Value – Fama -French Small Value Research Index (1970-2013) Russell2000 Value 2014-2015. Foreign Large – MSCI EAFE (net) from 1970-1974 and MSCI EAFE (net) Growth from 1975 – 2015. Foreign Large Value – MSCI EAFE (net) from 1970 – 1974 and MSCI EAFE Value (net) from 1975-2015. Foreign Small – DFA International Small Simulated Index (1970-2013) MSCI World ex USA Small Cap Index 2015. Foreign Small Value – DFA International Small Simulated Index from 1970-1981, DFA International Small Value Simulated Index from 1982-2013, and MSCI World ex USA Small Cap Index 2015. Emerging Markets – DFA International Small Simulated Index from 1970-1987 and MSCI Emerging Markets Index from 1988 -2015. REITs – Fama-French Small Cap Index from 1970-1977 and Wilshire REIT Index from 1978-2015. CPICPI actual 1970-2015.

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. Indices are not available for direct investment; therefore their performance does not reflect the expenses associated with the management of an actual portfolio. The index returns above assume reinvestment of all distributions. This information is for educational purposes only and should not be considered investment advice or an offer of any security for sale.