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Yesterday’s Influence

Adam M. Grossman

MY FIRST DAY IN the investment industry was—unfortunately—not so great. On the morning of Sept. 15, 2008, the investment bank Lehman Brothers filed for bankruptcy, sending the stock market into a free fall. The rest of 2008 was equally ugly, with the S&P 500 losing 37% for the year. But that experience provided investors with a valuable lesson—about the power of recency bias.

Recency bias is the mind’s tendency to extrapolate. When things are terrible, as they were on that day in 2008, it’s hard to imagine how or when things might ever get better. On the other hand, when markets are rising, it’s hard to imagine what might cause that positive momentum to slow.

Recency bias causes us to look backward—to assume that what happened yesterday will happen again tomorrow. That can lead investors to do the opposite of what would be best. Consider what we’ve experienced in just the past two years.

At the beginning of 2022, the stock market was on a tear. After hitting bottom in the spring of 2020, investment markets had been delivering steady gains for nearly two years. The economy was strong, and it looked like this good fortune would continue. But it was at that point that inflation readings began to become more problematic and, in response, the Federal Reserve began lifting interest rates. In all, the Fed raised rates seven times in 2022. The result for investors was punishing, with both stocks and bonds dropping at the same time—a rare occurrence. Stocks lost nearly 20% for the year, and bonds lost more than 10%.

By the end of 2022, investors weren’t feeling so good. Markets were down, inflation was still running high, and it was hard to see how things could improve. The notion that the Fed could engineer a “soft landing”—bringing down inflation without causing a recession—appeared remote. But just when sentiment seemed to be at its worst, inflation turned a corner. The Fed did continue raising rates into 2023, but the increases were smaller and sentiment improved. The result: Just when investors least expected it, stocks took off, gaining more than 25% for the year.

This describes just the past two years, but it’s a microcosm of investors’ experience nearly every year. Just when one trend appears to be well entrenched, something changes, upending expectations. It’s at times like this that recency bias can lead us astray. What can you do to combat it?

The simple answer would be to ignore the news. In fact, a famous study once tested this idea. Participants were given paper portfolios to trade and were split into two groups. The first group received regular news reports on their investments, while the second received less information. The result: Those who received less news ended up doing better with their investments. Having less information helped them avoid the confounding effects of recency bias. This finding was interesting. But unfortunately, it doesn’t have much practical value. It’s unrealistic for real investors with real portfolios to simply ignore the news. What else can you do?

My first recommendation is to study history. Look back at a chart of the stock market over the past 100 years, and you’ll see that, over time, it’s delivered gains of about 10% a year, on average. With the exception of the period following the 1929 crash, most downturns end up looking minor with the benefit of hindsight.

Another important step is to write out a formal investment policy with asset allocation targets—70% stocks, for example. This document should also include rebalancing guidelines, spelling out how you’ll move your portfolio back to those targets when it deviates. This type of investment policy is standard for investors working with advisors, but I recommend it even if you’re managing your own portfolio. Written guidelines can help investors overcome recency bias when it’s needed most.

What might you include in an investment policy today to help combat recency bias? Starting on the bond side, the key is to avoid fighting yesterday’s battles. Yes, the bond market has been through a difficult period, losing 13% in 2022, but it made back some of that ground in 2023. And it’s possible—and even likely—that this year will see further gains. With inflation much lower, the Fed has slowed its pace of interest rate increases. If the next step is for rates to decrease, that will be very positive for bonds. The upshot: To combat recency bias, try to look forward. Even though bonds have been an unpleasant place to be, that time may be past.

On the stock side of your portfolio, how can you sidestep recency bias? If there’s one longstanding trend that’s been testing investors’ patience, it’s the dismal performance of international stocks. While long-term data support international diversification, the outperformance of U.S. stocks for nearly 15 years has led many investors to question whether the world has changed. Since 2009, the S&P 500 has gained 646%, including dividends. Meanwhile, a diversified basket of international stocks has gained just 88%.

That gap is enough to test anyone’s faith in international markets. But it’s precisely at times like this that a written investment policy can be most helpful. That way, you can rely on the policy and avoid being influenced by where the market has been.

I’ll acknowledge that this isn’t easy, but this is where it can help to reference market history. Go back to the period between 2002 and 2008. Domestic stocks lost 4.5%, while international stocks gained 36%. History tells us, in other words, that the outperformance of U.S. stocks in recent years may not be permanent.

What else can you do to combat recency bias? Another key is to avoid volatile investments. Let’s look again at 2022. When the S&P 500 dropped 18%, stocks like Amazon and Netflix each lost about 50%. The tech company Shopify lost 75%. The lesson: Broad diversification helps moderate the ups and downs of a portfolio, and this can make it easier to avoid reacting to recent performance.

This applies to bonds as well. In 2022, when the overall bond market lost more than 10%, some bonds fared much better than others. Vanguard’s Short-Term Treasury ETF (symbol: VGSH), for example, lost less than 4%. As you structure your investment policy, remember that diversification is important for bonds too.

A final strategy to help combat recency bias: Always ask yourself, “What does this mean for me?” With so much market commentary out there, it’s easy to lose sight of what’s important. Suppose you’re in your working years and see the market drop. Counterintuitive as it might seem, a market decline is generally a good thing. It allows you to add to your investments at lower prices.

What if, like today, the market is hitting new highs? Some investors worry about the opposite problem—that it will be hard to make money buying at higher prices. There’s a logic to that, but this is again where market history can be helpful. Look back at other periods when the market was hitting new highs, whether it was 2000, 2007 or 2019. In each case, the market did indeed drop—but only temporarily. Today, the market is much higher than it was at any of those prior highs. It isn’t always easy, but—to the extent you can look forward rather than back—that’s usually an investor’s best bet.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.

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