I recently had the opportunity to study at the world’s first recognized collegiate business school – the Wharton School of the University of Pennsylvania. I was there for a week-long program as part of my CIMA certification, where I was able to learn from some of our industry’s best and brightest professors, network with colleagues, and explore the University of Pennsylvania campus.
One of the more interesting topics in the curriculum, to me, was behavioral finance theory. This is the study of the intersection of human behavior and financial markets and the biases that exist when people process information. One I frequently encounter when talking to other investors is recency bias – the tendency to believe with certainty that recent events are likely to reoccur. A good example is the 2008 Great Recession, where global equity markets around the world were down more than 50%. Not a great time to be in equities. How would investors with recency bias behave once the markets began to climb? Likely, they stayed away from equities and clung to the safe haven of bonds and Treasuries because they feared that performance would continue no matter what. But did it? How have equities performed since? Global equities have been up over 100% since 2008; that’s over 10% a year. A bad time to be out of equities. Just because broad equities underperform one year, or for several years, does not mean the trend will continue.
Although most investors seem to have moved on from 2008 and entered equities again, there are likely still areas they avoid due to lackluster recent performance. Emerging markets are a key culprit. Over the last five years, the emerging markets index has been negative 11.77%, or about 2.5% a year. Not great. Meanwhile, the U.S. market (Russell 3000 Index) has been up more than 14% a year. Investors probably have a bad taste in their mouths if they’ve invested in anything outside the U.S. recently.
Those with recency bias probably want to get emerging markets out of their portfolios and are wondering why they were ever there in the first place. To find that answer, we don’t have to go back too far: the 2000s, or the “Lost Decade.” During this decade, the U.S. market lost about 2% in total return, or about 0.20% per year. A decade without any gains in the market! Investors who owned only U.S. stocks were no doubt disillusioned, but investors who held globally diversified portfolios with a portion in emerging markets fared better. Emerging markets were up, over the same time period, more than 160%, or over 10% a year.
The point is no one knows where the market is going on any given day; it’s a coin flip. Investing is an exercise in probabilities, not certainties. Given an uncertain future, we must build balanced, globally diversified portfolios of assets that perform differently from one another under different circumstances to grow accounts steadily up to retirement. Avoiding recency bias is difficult; it’s just the way the human brain is wired. But hiring an outside money manager to take emotion out of allocation decisions can help eliminate this behavioral bias and realize your long-term goals.
When we ended the week at Wharton, we were tested on several topics, but behavioral finance was emphasized most because this affects each and every investor. It’s important to understand the cause and effect of each bias and work with the end investor to set reasonable expectations, maintain global diversification, and keep emotions in check. In the end, behavioral coaching is the most value added by a financial professional.