Don’t Invest in the Rear-View Mirror

Investors face many behavioral biases—that’s just part of being human. Perhaps the most difficult to overcome is recency bias: the tendency to believe what has happened in the immediate past is likely to continue in the future.

Although experienced investors understand short-term market movements are random, once patterns develop over three to five years the gurus start calling them new paradigms. Then they urge us to change that stodgy old strategy that isn’t appropriate anymore and encourage us to adapt to the new normal.

Problem is, while this sounds wise, it’s little more than performance chasing. What happened over the last five years cannot help you during the next five years—in fact, investing in the rear-view mirror is almost certain to produce disappointing results. To see why, let’s turn back the clock five years to the autumn of 2007, when investors were enjoying a full-on bull market following the tech wreck of the early 2000s. Imagine sitting down for a meeting with your advisor who shows you the following performance numbers:

These results are pretty dramatic: Canada absolutely pummeled the US even when performance is measured in local currency. And when you consider US stock returns in Canadian dollars, they look far worse: the greenback lost about 9.5% of its value annually during this period. Meanwhile, international stocks in both developed and emerging countries delivered outstanding returns to pick up some of the slack.

If you were inclined to reposition your portfolio based on these results, what would your asset allocation have looked like after that 2007 meeting? You likely would have loaded up on Canadian stocks and emerging markets. Of course, you wouldn’t have called it performance chasing—that’s something other people do. You would have rationalized it by saying that Canada’s resource-rich economy was well positioned in the global economy, and that emerging markets like China and India were poised for strong GDP growth. If you were inclined to invest in the US all, you likely would have elected to use currency hedging, because it was “obvious” the US dollar would continue its downward trend.

My, how you’ve changed

Well, we all know a lot happened over the subsequent five years. Let’s have a look at what the markets have delivered since November 2007:

As you can see, these numbers bear no resemblance to those of the previous five years. Not only have US stocks significantly outpaced Canada and the rest of the world (albeit with low returns by historical standards), but the US dollar appreciated more than 1% annually, which boosted returns for Canadian investors who did not use currency hedging. Emerging markets, the stellar performers of the mid-2000s, have delivered negative returns since then.

I’m constantly asked whether I think it makes sense to adjust my model portfolios to focus on dividend stocks, to allocate less to Europe, or to add exposure to gold. I hope my answer will be obvious: all three of these strategies would have performed extremely well over the last five years, and if I had a time machine, I would go back and change the model portfolios. But these recent trends tell us absolutely nothing about how to position our portfolios for the next five years.

The most sensible strategy, then, is to build a broadly diversified portfolio with a risk level that matches your investment goal and your temperament, and to rebalance regularly without making forecasts. It sounds so easy, but recency bias can make it awfully difficult to stick to that plan.