In this episode of Investment Strategy Made Simple (ISMS), Andrew and Larry discuss a chapter of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this second episode of the series, they talk about mistake number two: Do you project recent trends indefinitely into the future?
LEARNING: Hyper-diversify and rebalance your portfolio.
“You cannot run away from risks; you can only choose which risk you’re going to take. Hyper-diversify on as many different unique risks as you can, stay the cause, and rebalance.”
In today’s episode, Andrew continues discussing with Larry Swedroe, head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today Andrew and Larry discuss a chapter of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this second series, they talk about mistake number two: Do you project recent trends indefinitely into the future?
Did you miss out on mistake number one? Check it out:
Recency bias explained
According to Larry, most investors suffer from recency bias. Recency bias is that we tend to overweight whatever has happened in the most recent past, whether it’s months or years, and ignore long-term evidence. Say you’re watching a stock and go back to 1995 and notice that technology stocks in ‘96, ‘97, and ‘98 performed well. So you think the same performance will prevail, and now you buy tech stocks based on that recent trend.
If you buy things that have done well in the last few years, and now you think it’s safe, what you’ve done is bought high. You didn’t get those great returns but paid high prices. High prices generally mean you’ll get low expected returns.
Larry reminds investors that knowing your history is the best way to overcome recency bias. History tells us that all risk assets, gold, real estate, US stocks, small stocks, value stocks, high-yield bonds, etc., go through very long periods of poor performance. That means you don’t want to be subject to recency bias because you think three, five, or even ten years is a long time to judge performance. It’s not; otherwise, there would be no risk for an investor with a 10-year horizon. So you just have to wait it out.
An excellent example of that problem is when the S&P underperformed T bills for at least 13 years for three periods, from 1929 to 1943, from 1966 to 1982, and then again from 2000 to 2012. Of course, the stocks did great in the other half of that period, but you don’t get those returns if you’re subject to recency bias.
The never-ending game of buying high and selling low
The message that Larry tries to give investors is that there are no clear crystal balls. So don’t be subject to recency bias because you’ll forever chase and buy high and sell low. This is not a prescription for success. You cannot run away from risks; you can only choose which risk you’ll take. And if you don’t have a clear crystal ball, there’s only one logical answer; you should hyper-diversify on as many unique risks as possible and stay with the cause.
Also, rebalance your portfolio and do what Warren Buffett, maybe the greatest investor of all time, has told people to do: don’t try to time the market. But if you’re going to because you can’t resist, buy when everyone else is panic selling and sell when everyone else is getting greedy.
Reversion to the mean of abnormal returns
According to Larry, investors get hooked on recency bias and ignore that one of the most powerful forces in the universe is the reversion to the mean of abnormal returns, both good and bad. That’s not necessarily true of individual stocks. For example, a stock could do poorly and then eventually go bankrupt. But it’s true of country indices or any broadly diversified portfolio. When you have a terrible performance period, that’s likely a result of the fact that valuations are falling. And if valuations are falling, your earnings-to-price ratio is going up, which means your expected returns are going up. But investors run away from the bad performance instead of rebalancing their portfolio.
Is recency bias symmetrical or asymmetrical in our decision-making?
Larry believes recency bias is both symmetrical and asymmetrical in our decision-making. Whatever is done well, people jump on the bandwagon due to fear of missing out (FOMO). But on the downside, the impact is worse because losses have a much more significant effect than an equal-size gain and how we feel.
So if you invest $100, for example, you feel twice as bad when you lose that $100 than if you make it. If you turn it around to a million dollars, the multiple effects may be 10X. The bigger the number, the worse that ratio becomes. So what happens is, when markets are going down, you feel that pain and project that it’s going to keep going down. Now you want to get out. The key to avoiding this is to avoid taking more risks than you can stomach in the first place. Then stick with your plan, and don’t chase returns.
Larry also insists on being aware that our biases, like political bias, cause us to take action when inaction is almost always better.
Your labor capital has to be low in correlation to the equity risk
Larry says that many investors set up their asset allocation thinking they have a long investment horizon before they start to withdraw. So they believe they can wait out a bear market—and that’s true. But it’s only a necessary condition to take a high equity allocation, not a sufficient condition.
Larry advises investors to take on the sufficient condition: their labor capital should be low in correlation to stocks’ economic risks. Because if the stock market goes down due to a recession and you get laid off, you have to sell stocks when the markets have already crashed to put food on the table, so you lose your investment. Therefore, people whose labor capital is closely tied to the economic cycle risk shouldn’t take as much equity risk in the first place.
The risk of confirmation bias
You get an echo chamber effect when you read articles about disruptive industries, technologies, artificial intelligence, and all other hyped stocks. You hear precisely what you want, making you feel even better. Then you ignore all the other evidence. Now, you only see bullish signals, become more optimistic, and buy.
However, if you’re more open-minded and look at the negative information about a stock, you get a more balanced view. You’ll do better in the market than a person who hears one side of the story. If you listen to both sides, you’ll still underperform the market because of trading costs and too efficient markets. Still, you’ll only lose by a small margin.
Final thoughts from Larry
We’re all subjected to recency and confirmation biases. To overcome them, have a well-thought-out plan, write down your asset allocation, and hyper-diversify. Once a month or once a quarter, look at your portfolio and rebalance it. Then ignore what is going on in the market.
About Larry Swedroe
Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.
Andrew Stotz 00:01
Hello fellow risk takers and welcome to my worst investment ever stories of loss to keep you winning in our community. We know that to win in investing, you must take risks but to win big, you've got to reduce it. Ladies and gentlemen, I'm on a mission to help 1 million people reduce risk in their lives to join me go to my worst investment ever.com and sign up for our free weekly become a better investor newsletter where I share how to reduce risk and create grow and protect your wealth. Fellow risk takers this is your worst podcast Oh Is Andrew Stotz from a Stotz Academy and I'm today, I'm continuing my discussions with Larry swedroe, who is head of financial and economic research at Buckingham wealth partners. You can learn more about his story in Episode 645. Larry has a deep understanding of the world of academic research and investing in especially risk. Today we're going to discuss a chapter from his book investment mistakes even smart investors make and how to avoid them. Today, we're going to be talking about mistake number two, do you project recent trends indefinitely into the future? Larry, take it away.
Larry Swedroe 01:15
Yeah, so there's my book that you just mentioned, covers 77 investment mistakes. fireware, it was actually the second edition of a book. The first was called Rational investing and irrational times. That book covered 52 mistakes. Several years later, I had it up to 77. And if I were writing it today, it probably be around 90. Because I've learned there are other mistakes people make. And a lot of them are really interrelated. recency bias is the fact that we tend to overweight, that whatever has happened in the most recent past, whether it's months or years, and ignore the long term evidence. So if you think about that, what is likely to happen to that. So let's just go back to, let's say, 1995. And you're watching the market. And you see that high technology stocks, and 96, seven and eight, have done great, and you think and you read this time is different and everything. And you then go ahead, and now you buy based upon that recent trend. And you project that will go on, and definitely into the future. Because that's literally impossible, because the high tech stocks were returning like, say 30% a year, and trees don't grow to the sky. So what happens when you do that? If you buy things that have done really well in the last few years, and now you think it's safe boy, this is there, I think what you've done is board high, you didn't get those great returns, you're paying high prices, and high prices in general mean, you're going to get low expected returns, because in the short term, high prices get even higher. And that's how bubbles happen. And the same thing is true on the other side of the coin, if something does poorly for a number of years than they projected on so let's think about what happens. It's 1970s and 80s. Andrew, do you remember what was the few could think of equity investments? That was the best single place to be? What might it have been as a country?
Andrew Stotz 03:46
Good question. I mean, we were going through inflation in the 70s.
Larry Swedroe 03:51
And 80s was a great decade for some 70s Not so much. Right. But 70s and 80s. There was one country dramatically outperformed every Japan. That's right. And at that point, Japan had done now great far outperform the US for a long time, and of course their prices were high. And then everyone said, Well, we go to buy Japan, right. And by 1999, the Nikkei sorry by 1990. The Nikkei was just under 40,000. Having far outperformed. We were reading all kinds of articles that Japan Inc was snapping up the whole world. They were buying Rockefeller Center and famous golf courses. And there were no more semiconductor plants in the US Japan was dominating the world. And the next debt, you know, the next 32 years, the Nikkei has gone from about 40,000 today about 47,000 and investors who bet on that recent trend obviously got hurt. So the 70s and 80s, the international stocks outperform. And then investors flooded in, specify things like emerging markets, I'll just stop. And then the 90s, the US dramatically outperform. By the end of that decade, everyone's convinced that the US is now the place to invest. And the next decade, international and emerging markets far outperform. And so now they say, Okay, we made a mistake, we should have stayed the course. And now they buy emerging markets. And now, the teams that decade, the US at outperform. And now I would bet the odds favor, it's not a guarantee that international is likely to outperform, because it's us have outperformed by so much, that prices have gotten so high, reflecting those great returns, and now you have much lower expected return. But investors are persistently chasing returns. And then why would I buy emerging markets is having a very bad decade. And it's, you know, what you've been doing? Well, the so what I try to remind people is this. One of the worst mistakes, besides this recency bias, or the way to maybe overcome recency bias is know your history. And what history tells us is this. All risk assets, I don't care. You can name any asset you want, from gold to real estate, to US stocks, the small stocks, the value stocks, high yield bonds, it doesn't matter. They all go through very long periods of poor performance. And what that means is, you don't want to be subject to recency bias. Because you think that three years is a long time to judge performance. Five years is a very long time in 10 years as an attorney for emerging markets doesn't do well, for 10 years, why would I want to own it? Well, any good financial economists would tell you that 10 years with risk assets is likely noise, that has to be that risk that even over a decade, and NASA could do poorly, otherwise, there will be no risk for an investor with a 10 year horizon, just have to wait it out. So good examples of that problem is there are three periods this shocks most people have at least 13 years with the s&p underperformed T bills from 29 to 43, from 66 to 82. And then again, from 2000 to 12. Now, of course, the other half of the period of that where stocks did great, but you don't get that as rose returns. If you're subject to recency bias, the last decade it did terrible. So I'm getting now I don't want to own that. The message that I try to give investors is this. There are no clear crystal balls. Don't be subject to this recency bias, because you will be forever chasing and buying high and selling low, which is not exactly a prescription for success. We have to You cannot run away from risks. You can only choose which risk you're going to take. And if you don't have a clear crystal ball, there's only one answer. That's logical, you should hyper diversify on as many different unique risks as you can, and then stave a cause. And that means rebalancing. So when something does well recently, you're not jumping on the bandwagon you're jumping off and removing some of your assets to get it back down to your say 10% allocation. Because now it's 13 because it's done well. And you're buying what's done poorly that forces you to do what Warren Buffett, maybe the greatest investor of all time, has told people which is don't try to time the market. But if you're going to because you can't resist, buy when everyone else is panic selling and sell when everyone else is getting greedy. That's what rebalancing forces you.
Andrew Stotz 09:45
It reminded me of a story because I moved to Thailand. I came to Asia for the first time in 1989. So right at the tail end of that Japanese boom. And then I moved to Thailand in 1992. And I got my first job in the stock market. 9093 I can remember it was September 1993, in between September and January of 1994, the Thai stock market doubled. And it hit a peak at 1789. That was in 1994. January. So the end, Lizzy 93. And to this, then it fell 90%. And if you put it in us
Larry Swedroe 10:30
and almost caused the global crisis. And if you
Andrew Stotz 10:33
look at it, if you put it in US dollar terms, because the baht also absolutely collapsed, you're talking about a 95% Fall in US dollar terms. And so just because you mentioned that about Japan, I looked at the stock market right now. And today, it's not at 1789. So here we are 30 years later, and it's at 1300, I say 1037. So about 1000. So it still has not recovered, just like Japan. And that's where I think people don't realize how long a down cycle needs to happen. When you have such a bubble, you know, or an extreme rise.
Larry Swedroe 11:15
And that's another thing that investors get hooked in is recency bias, they ignore that one of the most powerful forces in the universe is reversion to the mean of abnormal returns both good and bad. Now, that's not necessarily true of individual stocks, for example, a stock could do poorly and then eventually go bankrupt. Right, but it's true of country indices, or any broad diversified portfolio. When you have a bad period of performance, that's likely a result of the fact that valuations are falling. And if you have valuations falling, your earnings to price ratio is going up, which means your expected returns are going up. But investors run away from the bad performance. Instead of rebalancing their portfolio,
Andrew Stotz 12:14
which, you know, you use the example for recency bias in kind of the gogo years when something's really exciting. But now let's look at the other side. When markets are really down in all the news is negative. Do E's have the same? Is it the same type of recency bias? Or is it even worse, that we're even more concerned about the downside, and therefore we just never gonna put our money? And I know in this mistake number two, in the chapter in your book, you talk about John Bogles, the yawning gap between fun returns and shareholder returns? How do we think about recency bias? Is it symmetrical or asymmetrical in our decision making?
Larry Swedroe 12:59
No, it's definitely I definitely works on both sides. Let's say that, so whatever is done, well, people jump on the bandwagon. Let's use the term fear of missing out or FOMO. Right. Okay. But on the downside, we know it's actually worse, because losses have a much bigger impact than an equal size gain and how we feel. So if you just take $100, for example, we feel twice as bad, we lose $100 than if we make it. And if you turn it around to a million dollars, that maybe the multiple is 10. And you know, the bigger the number gets, the worse that ratio becomes. So what happens is, when markets are going down, we feel in that pain, and you project that's going to keep going down. Now your stomach, here's what I think happens, your stomach starts to screen, what I call GMO, which is get made out. And I've yet to meet a stomach that makes good decisions. Which the key to avoiding that is don't take more risks than you can stomach in the first place. And then just stick with your plan and don't chase returns. So that's how you deal with that. But I can't tell you how many calls I've gotten in recent weeks bixin silica Silicon Valley back then invest answering Larry this, this I should have, I want to sell everything and buy gold. And I said I bet you're a Republican. And without even knowing I never met this person. And I would be willing to put money on it. Not with certainty but more than a 5050 bet. Because one of the biases that we have is a political bias. And there's a really interesting study is on this. So I'll mention, why did I think it was a Republican? Because here's what happens when the party you favor is in power you are and bad things happen? Are you more likely to think that they will take actions to correct the problem, or you're more likely to think that the problem will get worse? And think about it from the other side, when the party you don't like, is in power?
Andrew Stotz 15:34
The opposing party is going to mess it up. Right?
Larry Swedroe 15:39
Exactly. And your party will fix it. So the research shows, for example, in the US, if you were a Republican in the Bush administration in 2008, you got better returns than the Democrats, because we had these crisis 2001 that war, since stuff like that Republicans would think they'll solve the problem, we'll get out of this recession 911 events, and they didn't panic and sell or much less likely to do so. And the Democrats who are more likely to say, This guy's a dummy. He's going to screw it up, and they will panic and sell. Then when Obama became president, Democrats got better returns, whether Republicans were the one saying we're in this crisis, you know, we'll never get out of it. Obama, you know, they'll screw it up. And then when Trump was president, Republicans got better return. And I would bet that the Democrats have, well, we're not I can't be sure yet on this one, because the market crashed 2022. So the Republicans who got out of the market may have done better, but the term isn't over yet. So we have to be aware that our biases, like political bias, cause us to do take action, when inaction is almost always better. And
Andrew Stotz 17:05
one of the other reasons why that I would argue the reasons he buys can be even more painful or difficult in the downmarket times when the economy's bad and thinking it is because there are secondary effects. I mean, when in 1997, when the economy collapsed, and the market collapsed in Thailand, my business that I had started with my best friend, a coffee business, the factory, basically, our customers dried up. And then I lost my job, as you know, working as an analyst at an investment bank. And then we decided to move into the factory. So here we are in the factory to preserve assets and all that, yeah, if I have access assets, it's a very real reasoning that I could lose my job, I could lose my salary, things could really fall apart. So it expands beyond now when it's the stock market rising, you're like, Yeah, wow, I can buy a house. Now I can buy this car. And it's a different feeling. So and in some cases, it was very real, I did lose my job. And my business went through a very tough, tough time. So I would say we're really susceptible to that recency bias, when the news is bad, or
Larry Swedroe 18:20
clearly one of the things I write about in my books, like the only guide you'll ever need for the right financial plan, or your complete guide to Successful and secure retirement, a lot of investors when they set up their asset allocation, they think about their investment horizon and say, Well, I've got a long horizon, say I'm 40 years old, I've got to be investing, say, at least for 30 years before I would start to withdraw. I come with wade out of their market. Well, that's true. But it's only a necessary condition to take a high equity allocation, not a sufficient condition, the sufficient condition is your labor capital has to be low correlated with the economic risks of stocks. Because if the stock market goes down, because you're in a recession, you could get laid off, and now you don't have a job. And now you have to sell stocks, when the markets already crashed and put food on the table and you can't recover. So a tenured professor at Yale, or a doctor can take more economic cycle risk and therefore hold more stocks, or a government worker or teacher, civil servant can take more, at least in the US anyway. take more risks that may be a construction worker or an automobile worker and somebody who is much more prone to being laid off home here in our home construction, business, etc. Those people should not take as much equity risk in the first place, because their labor capital is closely tied to the economic cycle
Andrew Stotz 20:10
risk. Yep. And I want to I don't want to go off this topic without talking about this concept of fun returns in shareholder returns that John Bogle did. Because is this evidence of our bad behavior? I mean, from recency, bias and other biases? Can you explain about that?
Larry Swedroe 20:32
Yeah. So there's a difference between mutual fund returns and the returns that investors in that fund actually earned. So Peter Lynch once told this story, how, during a relatively bad period for him, he just barely beat the market. He went the it's funded going up, and then went down and then came back up, but his fund outperformed. But the average investor in his fund actually lost money. And the reason is, they watched the fund do great recency bias causing them to buy, then the fund did poorly. And then they sold. And then of course, the fund recovered, but they weren't that. Great. The best example recently, of this recency bias, and the gap between fun returns and investor returns would be Kathy woods, and her Ock mutual fund. Kathy, the first couple of years the fund was this little fun, no one was paying attention to it had mediocre returns. And then it had spectacular returns for a couple of years, up through about 2021. And the returns, like the first year was up 100%. And next year up another big, but the fund that almost no assets by the time at the end of 2021, say or somewhere around there to fund that billions. Why? Because everyone wanted to jump on that bandwagon, that FOMO Fear Of Missing Out recency bias, and then the fund dropped 70%. And so the returns over the five year period was still okay. But the average investor had massive losses. Because they bought the fund when it was up here, and it ended up down there. And that's the perfect example of that, you know, happening. I'll give you one other example that everyone can relate to, was Bitcoin. I mean, Bitcoin started out worth pennies, right. And it was when it was trading at about 20,000, a few months ago, before the recent rally. Last I looked, it was about 28. The average investor had lost money. How could that be went from pennies, right? Because a lot of people bought it 30 and 40 and 50, and 60. And 69,000, I think was the hot. So the average investors cost, I think was something like 20,000. And it got down to 16,000 before it rally. So that's a great example of the gap. Now, I think there's obviously some net profits. But we'll see what happens.
Andrew Stotz 23:32
So I want to read this paragraph out of your book, because I think this is a great way to wrap this discussion up. Because I think that it's a bigger effect than what people think. Okay, yeah, so I make some bad decisions now and then, but here's what you said. We also have evidence from a study done by the Bogle Financial Market Center. The sample consisted of the 200 funds with the largest cash inflows for the five year period 1996 through 2000, the time weighted Return of the funds and the dollar weighted return of investors in those funds. Were compared for the 10 year period 1996 to 2005. The average time weighted return for the 200 mutual funds was 8.9% per year. So that's a 9%.
Larry Swedroe 24:20
Now, that's the return that the fund reports. If you look at Morningstar, or you get a annual report, that's the number that they will show. Yep. And
Andrew Stotz 24:31
then you say however, the actual dollar weighted return earned by investors was just 2.4% a gap of 6.5% per year. That's just shocking. How could it
Larry Swedroe 24:48
I don't think that's representative of the typical average investor experience. But that is the reason you see that is that was a period of boom and bust If you have a more normal markets are going up steadily at a certain pace, then you probably don't see, you might see a gap of one or 2%. But not as big as that. But when you get booms and then busts, like with Kathy woods and Ock, you can see massive differences between the time weighted and dollar weighted returns of funds.
Andrew Stotz 25:25
Yeah, I just found that, you know, absolutely fascinating. I remember reading, you know, his work many years ago, and realizing that we really can do a lot of damage to our return, if we get caught up in recency bias. So what I'd like to do is just kind of highlight to everybody who's listening, is that one of the first steps that you got to take in this case is understand that you are subject to recency bias. And if you can step back, when you're being flooded with information, that you step back, and try to understand that a little bit more. That's the first step. And I guess the second step is that if you are doing something such as dollar cost averaging, well, you're pretty much taking care of the recency bias, because you're just buying, you know, on a continual basis, no matter what's happening. So is there any wrap up that you would give, to help people think about how to make sure that you don't fall for recency bias?
Larry Swedroe 26:29
Let me add one thing, and then we'll wrap it up in it. Another related problem with recency bias, is confirmation bias. And so if you think that they're you reading all these articles about these destructive or disruptive industries and technologies, artificial intelligence, and all the kinds of stocks that Kathy woods are buying, and you read an article talking about that, and you what tends to happen is we get an echo chamber effect, we hear exactly what we want to hear, and then it makes us feel even better. And then we ignore all the other evidence. So for example, AI may help these companies that are high tech creating it, but it may help Walmart much better in terms of how it serves his clients and, and which products to put on the shelves. And, you know, and, and all those kinds of helping CVS and all these store, all these value companies, traditional manufacturers are using that same AI to help. So there's a really a brand new paper on this echo chamber effect. And what they found is this, when people read Twitter or tweets about a stock that they like, and they only see the bullish signals, because they follow people who are recommending say Tesla and you like Tesla, that will cause them to become more optimistic and biotech. However, if they are more open minded, and follow people say I also want to see what the negative saying. So I get a more balanced view. Those people do better in the market, the ones who a year on the one side of the story, have very poor returns. The ones who listen to both sides still underperform the market, because of trading costs and the markets too efficient, but they only lose by a little bit. They tend not to be heard as bad. So this confirmation bias can really compound the problem. And lots of other biases, like your political bias can compound the problem. So how do you overcome this? What is smart people do to avoid those mistakes because we're all subjected to those biases? Everyone, I'm subjected to him, but I work hard because I know about them. And I work hard to avoid, there's a simple solution. Have a well thought out plan you write down your asset allocation should be hyper diversify. And then once a month or once a quarter, just take a look at it and rebalance and ignore what is going on in the market. There's actually a study that shows there's a negative correlation between how often you check your portfolio's values and your returns. you're best off being Rip Van Winkle and go to sleep for 20 years, you're likely to have better returns than if you're on your cell phone every hour checking what's going on with stock prices or anything else. So that's my advice. Have a well thought out plan and learn how to Write it in my book. You're a complete guide to a successful and secure retirement.
Andrew Stotz 30:06
Well, Larry, thank you for another great discussion to help us create, grow and protect our wealth. And for listeners out there, you can go to Amazon is probably the easiest place to see all of Larry's work, including the book that we're talking about investment mistakes even smart investors make and how to avoid them. This is your worst podcast host Andrew Stotz saying I'll see you on the upside.
Connect with Larry Swedroe
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Further reading mentioned
- Larry Swedroe and RC Balaban, Investment Mistakes Even Smart Investors Make and How to Avoid Them
- Philip E. Tetlock, Expert Political Judgment: How Good Is It? How Can We Know?
- Carol Tavris and Elliot Aronson, Mistakes Were Made (But Not by Me): Third Edition: Why We Justify Foolish Beliefs, Bad Decisions, and Hurtful Acts