What was the last movie you watched? You likely can recall the title of the movie, who you were with, and where you were when you watched it with relative ease.

What movie did you watch in February of 2004? It is likely that you have much more difficulty recalling the name of that movie!

Human beings naturally recall the performance of their investment portfolios in the same way. We remember recent performance more clearly than we remember more distant performance. This psychological phenomenon is known to those who study Behavioral Finance as “Recency Bias”. Recency Bias can impact and distort our view on our investment portfolio performance.

There is another psychological phenomenon that can supersede Recency Bias, and that is called Loss Aversion. We seem to remember the anxiety and fear we felt when our investment portfolios experience negative volatility. We do not like to see our investment portfolios lose value, even if it is a temporary paper loss. In some cases, Loss Aversion can lead to the classic mistake of wanting to “get out and sell everything”, which can derail long term financial plans as markets cannot be timed with any consistency. For most people, the pain of seeing “losses” outweighs the pleasure of seeing “gains” in their investment portfolio.

In the following illustration, one can see that over time negative volatility is a minor and temporary part of the long term picture:

The chart above represents a summary of annual returns for US Large Stocks, US Small Stocks, Non-US Large Stocks, Non-US Small Stocks, US Bonds, Inflation, and two portfolios. One portfolio is 60% stocks and 40% bonds (Details in the fine print). The other is 70% stocks and 30% bonds (detail again is in the fine print).

The portfolios were rebalanced quarterly during the 39 year period from 11/1980 to 11/2018. The following information is derived from the tables below.

Over the time period, US Large Stocks produced positive nominal calendar year returns 82% of the time and returned an average annualized return of 11.67%. If you adjust the returns for inflation , US Large Stocks produced a positive real average annualized return of 8.54%.

Over the time period, the 60% stock portfolio produced positive nominal calendar year returns 90% of the time and returned an average annualized return of 10% with much less volatility than the S&P 500 (with annualized standard deviation of 11.16% for the 60% stock portfolio versus 15.79% for the S&P 500). If you adjust the returns for inflation , the 60% stock portfolio produced a real average annualized return of 6.87%.

Over the time period, the 70% stock portfolio produced positive nominal calendar year returns 87% of the time and returned an average annualized return of 10.4% with much less volatility than the S&P 500 (with annualized standard deviation of 12.59% for the 70% stock portfolio versus 15.79% for the S&P 500). If you adjust the returns for inflation, the 70% stock portfolio produced a real average annualized return of 7.27%.

In contrast, over the time period, US Cash produced positive nominal calendar year returns 100% of the time and returned an average annualized return of 4.3%. If you adjust the returns for inflation, US cash produced a real average annualized return of 1.17%.

It is important to note that due to the way cash flows work over a lifetime, it is critical to reduce volatility in a portfolio. This is evidenced in the difference in percentage of positive return years between the S&P 500 and the two diversified portfolios. However, some risk must be taken as evidenced by the difference in return % between cash and the two diversified portfolios.

Keeping the long-term asset class performance in mind will hopefully reduce the negative impact on Recency Bias and Loss Aversion in periods of high market volatility. In any short time period, such as two years, even a diversified and well-managed portfolio can experience negative returns (such as 2001 and 2002). The long-term expectations of a diversified portfolio can only come to fruition over a long period of time.

The critical takeaway here is that we should not allow Recency Bias or Loss Aversion to cause us to make the mistake of trying to time markets, and instead we should maintain the long-term focus our financial plans are based on and allow markets to work for us. We receive higher returns for investing in riskier assets than cash precisely because they are risky, and we need to achieve those returns to protect purchasing power over time against the sneaky and insidious risk of inflation. Allowing emotion to dictate our actions in lieu of evidence-based and well researched methodologies can be disastrous to long term goal achievement. The challenge is to overcome our natural instincts and “fight or flight” response to markets and maintain discipline and a long-term focus, and it is a challenge that must be met in order to live the life we envisioned for ourselves.

If you have any questions or would like more information, please contact your Lake Tahoe Wealth Management Financial Planner today!

Sources of Data:

Disclosures:

Lake Tahoe Wealth Management, Inc. is an SEC Registered Investment Advisory Firm. Past performance does not guarantee future performance. There is a risk of loss with investments. The diversified portfolios represented in the illustrations above do not represent Lake Tahoe Wealth Management, Inc. portfolios. The illustrations above represent historical performance of indices and do not represent performance of Lake Tahoe Wealth Management, Inc. portfolios.