2014 got off to a rough start… of course now that things have stabilized, it is hard to recall the rough start. That is an example of “recency bias” in action. Recency bias is our tendency to use recent experiences as the baseline for what will happen in the future.
When the market is down, we become convinced it will remain at a permanent low. When the market is up, we become convinced it should keep going up. When interest rates are dismally low, we become convinced they will stay low forever. Although at the time we may feel convinced of it, that doesn’t make it so.
Reviewing what has happened helps bring perspective so we don’t get quite as caught up in recent events. To review, let’s take a quick look at this past quarter.
At the beginning of the year, the market did go down (the S&P 500 was down about 5% and the Dow Jones Index was down about 7% as of the first few days of February), then, despite Russia’s annexation of Crimea, evidence that growth is slowing in China, and a changeover in Federal Reserve leadership, U.S. stocks managed to accrue a mild gain for the quarter. U.S. large cap stocks were up 1.8% and small caps up 1%.
These first quarter fluctuations should serve as a solid reminder that short term market fluctuations have no impact on your long-term financial success. When times get turbulent, if you find yourself watching a lot of financial news and getting caught up in it, try a different tactic.
One client told us that about a year after he hired us he and his wife simply stopped watching any shows that focused too much on financial news. They report they have found life to be far more relaxing now. This sounds like a smart approach.
You don’t have to keep up on financial news because we do keep up on it – but not the kind you see reported on TV or in Money Magazine. The reports we read each month are put together by institutional investment firms and cover financial data at a level of depth that far exceeds what can be reported on TV.
This past month, here are some of the near-term (one year out) future economic expectations included in the research we read:
- Inflation to remain subdued
- Business spending/investment to pick up
- Increased consumer spending due to improvement in income growth, job gains, and replenished household balance sheets
- Leading economic indicators signal modest economic expansion
- Interest rate increase expected around spring 2015
This all sounds positive. After the past five years, stability and continued growth are welcome.
With this positive news, we have many clients who have asked about increasing their allocation to the growth (equity index fund) portion of their portfolio. Once again, this is recency bias in action.
Current economic news should not drive your personal investment decisions. If you are a business owner, current news may affect how and when you expand and market your business, but it shouldn’t affect the level of risk you take in your portfolio.
Here’s an example: if consumer spending is likely to increase, a business owner might decide it is a good time to open a new location. This is logical.
But if that same business owner also decides it is time to put a lot more of their IRA money in stocks – that is where the logic breaks down. The equity market is a leading economic indicator, so the stock market is likely to go up months and months in advance of this potential increase in consumer spending. Economic forecasts cannot be used to time market moves.
Despite what the media may lead you to believe, the economic data that the media focuses on has little relevance to your own level of financial security. This point is well made in GMO’s Investing for Retirement whitepaper (April 2014) where they say,
“An investor for retirement has fairly well-defined needs, both in terms of how much wealth he needs to accumulate and his pattern of consumption in retirement. An investor’s portfolio should be driven primarily by his needs and circumstances – what does he need and when does he need it.”
Your needs and circumstances should always be the foundation of your portfolio decisions – and that is exactly the approach we take. Does this approach pay off? Research studies report that it does. Here’s a sampling of what Vanguard and Morningstar say about the value of ongoing advice.
Vanguard’s March 2014 Advisor’s Alpha whitepaper says,
“Based on our analysis, advisors can potentially add “about 3%” in net returns…”
On a $1,000,000 portfolio, 3% net returns adds up to $30,000 a year.
Morningstar’s September 2012 Alpha, Beta, Gamma paper says,
“We focus on five important financial planning decision/techniques… each of these five components creates value for retirees, and when combined, can be expected to generate 29% more income…”
For a retiree with $100,000 of income, 29% more income stacks up to $29,000 a year.
What types of decisions lead to such results? All of the following items have been shown to contribute to improved results in terms of after-tax returns, future retirement income, and total wealth:
- Cost-effective implementation (using low expense ratio funds)
- Behavioral coaching
- Asset location (which funds go in which types of accounts)
- Spending strategy (withdrawal order)
- Capital gains management (harvesting gains and losses)
- Strategic Roth conversions (converting IRA money to a Roth when appropriate)
Notice not one of these things has to do with the latest economic data. Most of these things have to do with your personal circumstances.
We find it silly that so much of the investment world focuses on external factors that have no proven ability to add returns to an individual investor. That’s why we’ll continue to focus on the personal factors that have been proven to deliver results.
*Returns data in graph above from Advisor Intelligence. When possible We report index fund returns to show performance net of fund fees. As such in the graph:
Total Bond Market Index is: Vanguard’s Total Bond Market Index Fund(VBMFX)
US Large Cap is: Vanguard’s 500 Index Fund (VFINX)
US Small Cap is: Vanguard’s Small Cap Index Fund (NAESX)
Real Estate is: Vanguards’s REIT Index (VGSIX)
International Large cap is: Vanguard’s Total International Stocks Index (VGTSX)
International Small Cap is: MSCI World Ex USA Small Cap Index (not a fund)
Emerging Markets is: Vanguard’s Emerging Market’s Index Fund (VEIEX)
(Investment Sense is an almost-monthly posting of market commentary with a common sense twist. For all our latest commentary follow us on Facebook.)