Beware of the Recent
By: Sam Swift, CFA, CFP®
It seems silly to discard nearly ninety years of history after one week or month of a market downturn, but investors* make this mistake frequently and repeatedly. In the study of behavioral investing, there’s a common trait called recency bias. The financial media (and most media) demonstrates this bias strongly which is how you end up with this
one month after one of the best years for stock returns in history.
Seriously, read those sub-headlines. “Dow falls 2.1%, and it may not be over.” “February is looking an awful lot like January for investors. Emphasis on awful.” I guess that’s what happens when you need to update your homepage every hour. And by the way, let’s remember that the Dow is 30 industrial stocks in the U.S. and hardly representative of the market. I’m convinced the only reason it’s quoted is because it is the biggest number. You can create a much scarier headline with “Dow tumbles 326 points” than with “S&P 500 tumbles 42 points” even though the latter is a larger percentage drop. (FYI: I could have put this last paragraph in all caps, but managed to resist. I just yelled at my computer screen instead.)
Unfortunately, actual investors are also susceptible to recency bias and the media certainly isn’t helping them cope. I wanted to list some numbers that may help you keep all this in perspective. First, let’s look at some different return periods compared to February 3, 2014 (the date of the headlines above) for the S&P 500. These numbers are annualized and through the end of January.
Obviously February 3, 2014 wasn’t the only down day in the market’s history. In fact, close to half of trading days result in negative returns—funny, it’s almost as if daily market returns are completely random!—and yet, the long-term returns march on.
This is the 19th time U.S. markets have dropped more than five percent since 2009. The S&P 500 even dropped 19.4 percent between April and October 2011 alone. Annualized returns since 2009 with those drops included were near 20%.
The U.S. markets average a double digit drop almost every 11 months. Annualized returns over the history of the market are more than 10%.
None of this is to say that the next year will be awful or great. I don’t know. I do know that the fantastic long-term returns we’ve experienced through history have occurred despite frequent, and often severe, short-term drops in value.
Your most powerful ally against recency bias and other behavioral traps is to plan properly and constantly. Remember that the amount of risk you take in your portfolio should be based on giving you the best chance to reach your goals, not on the most recent headlines or predictions.
*Those that attempt to time the market should really be referred to as “speculators”. True Investors wouldn’t do this.