Larry Swedroe: There’s a Perfect Storm Brewing

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Expert Analysis and Commentary

Larry Swedroe: There’s a Perfect Storm Brewing

Larry Swedroe Dec 22, 2014

It seems like the markets are conspiring against investors. They are producing outcomes likely to tempt many investors, even some of those with well-thought-out plans, to make the types of behavioral mistakes that could lead to the failure of their long-term financial plans.
My book, Investment Mistakes Even Smart Investors Make and How to Avoid Them, describes 77 errors that investors are prone to committing. Among them is one that I call the mistake of recency — defined as the tendency for investors to buy yesterday’s winners and sell yesterday’s losers.

Investors act as if it were possible to buy yesterday’s returns when, in fact, they can only buy tomorrow’s. To examine how the markets seem to be conspiring against investors, let’s take a look at the recent relative performance of the S&P 500 and the MSCI EAFE Indices.

Studying the Markets’ Recent Past

From 2002 through 2007, the MSCI EAFE Index outperformed the S&P 500 Index for six straight years, earning investors an annualized return of 14.8% per year. By comparison, the S&P 500 returned just 6.1% per year. Many investors “discovered” the benefits of diversification during this time.

However, the tables have since been reversed. From January 2010 through October 2014, the S&P 500 posted an annualized return of 15.5 percent per year while the MSCI EAFE returned 6.5 percent per year. And the S&P 500 outperformed in each year during that period with the exception of 2012, when the MSCI EAFE managed to outperform by 1.9 percentage points. That kind of performance can lead investors to abandon their well-thought-out plan calling for the diversification of economic and geopolitical risks.

The risks created by the recent relatively poor performance of international stocks may be heightened because many investors are also prone to making a second and related mistake. They tend to confuse the familiar with the safe. That, in turn, leads to a home country bias in their portfolios.

A small home country bias can be justified because international investing is both slightly more expensive and slightly less tax efficient. But, with the U.S. market now at about 50 percent of the global market capitalization, an allocation of much more than 60 percent to domestic stocks would be a sign of home country bias.

Unfortunately, investors all around the globe exhibit a home country bias. But Lake Wobegon exists only in fiction. It cannot be that every developed country is safer than the others. Compounding the problem is that investors tend to believe not only that their home country a safer place to invest, but also — defying a basic concept in finance that risk and expected return are related — that their own country will produce higher returns.

Tracking Error Regret

Making matters even worse is that when international stocks underperform, the dreaded psychological disease known as tracking error regret rears its ugly head.

Tracking error regret occurs when a diversified portfolio underperforms a popular benchmark, such as the S&P 500. No one ever complains when their diversified portfolio outperforms the S&P 500. In that case, the tracking error is positive. But many investors panic when their portfolio underperforms a given benchmark, creating negative tracking error. Of course, if positive tracking error exists, so too must the possibility for negative tracking error. And that leads us to a third mistake investors tend to make. I call it confusing strategy with outcome.

In a world where you cannot see the future, we should never judge the correctness of a strategy by the resulting outcome. We should only judge the correctness of a strategy before we know the outcome, not afterwards. Either the strategy is correct before the fact, or it is wrong before the fact.

Try thinking of it this way. Diversification is like insurance. It’s insurance against having all your eggs in the wrong basket. And a strategy that involves buying insurance is working whether or not you collect on the policy. I don’t know of anyone who complains when they don’t collect on their life insurance policy, but I know many people who complain when their diversified portfolio underperforms.

Nassim Nicholas Taleb, author of “Fooled by Randomness,” explained it this way: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (i.e. if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”

Warren Buffett has said that “the most important quality for an investor is temperament, not intellect.” He has also advised that “success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.”

The Bottom Line

There’s a perfect storm brewing that will test your investment temperament. You have now been forewarned about the problems associated with recency, home country bias, confusing the familiar with the safe, tracking error regret and confusing strategy with outcome. Hopefully, being aware of these common mistakes will allow you to maintain your discipline.
Larry Swedroe is director of research for The BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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