Symmetry Perspectives

Combatting the “Recency Effect”: Lessons from History

At a recent conference sponsored by Morningstar Ibbotson the keynote luncheon speaker, Pat Dorsey, Morningstar’s Director of Research spoke about how insights from behavioural finance can help investors make better decisions.

One of the behaviours Dorsey talked about is the recency effect – a cognitive bias whereby we give undue emphasis to recent events and then project them out into the future. In an investment context, if markets have been strong recently, we expect them to remain strong. If they’ve been weak, we expect them to remain weak.

With equity markets down over 50% from peak levels, it’s no wonder that investors are paralyzed by fear. Cash is approaching record levels. RRSP contributions are down. And for those making contributions, money market funds are the investment of choice. Better to put your money under the mattress than risk further losses in the markets. Sadly, for those who rely on personal savings to fund their retirement, they are most likely facing a lower level of income.

Because it’s so ingrained in our subconscious minds, Dorsey says that the best way to combat the recency effect is to look at more history.

When we examine all Canadian equity market declines greater than 30% since the 1920s, we found that subsequent one-year returns from trough levels averaged over 35%. Subsequent ten-year returns averaged 12.5%, which are well above the long-term compound average return of just below 10%.

Here, we will broaden the discussion to make some comments on both stocks and bonds and the effect of having an allocation to both in an investor’s portfolio.

Let’s look at some charts. Charts 1 and 2 show the annual returns of the S&P 500 and US intermediate-term government bonds from 1926 to 2008. Chart 3 shows the returns of 50:50 allocations to each. We have chosen to use US data due to its longer history. Results would be similar using Canadian stock and bond returns.

A few observations

Over 83 years, the S&P 500 experienced a compound annual return of 9.6%. Of those 83 years, 59 (71% of all years) have had positive returns while 24 (29% of all years) have experienced negative returns. The worst calendar year return was in 1931 when the S&P 500 dropped 43.3%. 2008’s return of -37% is the second worst on record. The best calendar year return was in 1933 when the market returned 54%. Coincidentally, 1933 marked the bottom of the Great Depression with unemployment reaching a staggering 24%.

Over the same period, intermediate-term government bonds experienced lower returns but with considerably less volatility and only eight years had negative returns. The worst return was in 1994 with a return of -5.1% while the best was in 1982 when mid-term government bonds returned 29.1%.

Not surprisingly, a 50:50 balanced weighting provided returns and volatility that were situated between stocks and bonds.

On a calendar year basis, one can draw some obvious conclusions.

1. Stocks outperform bonds over the long run but are much more volatile.
2. Stocks tend to go up more often than they go down.
3. Multi-year periods of consecutive gains are more common than multi-year period of losses. (The latter have, however, occurred – three years of consecutive losses in 2001-04 and 1940-43 while four years occurred in 1929-32.)
4. Bonds have lower returns but are a lot less volatile than stocks.

Charts 3 shows the range of returns over various holding periods for stocks, bonds and the 50:50 mix. Note how the range of returns narrows as holding period lengthens. Stocks had the highest upside over all periods. In terms of downside protection, bonds were clearly best for shorter time horizons. But for longer periods, bonds offered less downside protection. Over ten-year periods, the 50:50 mix had the best downside result while over 25 years stocks fared best of all on both upside and downside return.

Over 25-year periods, the peak return of +17.3% occurred over the period 1974-1999 as the markets started in the 73-74 bear market and ended at the height of the tech bubble. The lowest 25-year period was 1928-1953 when stocks returned 5.9% but still outperformed 50:50 (+5.4%) and bonds (+3.4%). It is encouraging though that the 25- year return for stocks from the worst year 1931 through to 1956 was 13.4%, comfortably above the long run average.

While today’s economic conditions continue to deteriorate there are a number of encouraging signs including aggressive central bank easing, massive fiscal stimulus and some indication that volatility is declining and credit spreads are beginning to narrow. Over longer periods, market returns will be governed by valuation and these appear increasingly compelling. P/E’s on normalized earnings are below historical averages and dividend yields are higher than government bond yields for the first time since the 1950s. Valuations for corporate credit are also compelling with pricing that reflects implied default rates that are five times higher than what was actually experienced in the 1930s.

Given our collective predisposition to focus on the recent past, it is understandable that investors are feeling shell-shocked and continue to favour cash and government bonds over riskier assets. However, the overwhelming evidence from historical experience suggests that to do so would be a mistake. If an investor has a long-time horizon, equities should capture the lion’s share of one’s portfolio. For investors with a medium-term horizon, a balanced mix is most likely the best choice in terms of providing reasonable growth but superior downside protection.

Symmetry One Portfolios offer a range of asset mixes that are designed to match various investment time horizons and risk tolerances. Symmetry One Growth Portfolio with its mix of 80% equities and 20% fixed income is a good choice for the long-term investor. Investors with a medium/longer term horizon should consider Symmetry One Balanced (50:50) and Moderate Growth Portfolios (65% equity/35% fixed income). Symmetry One Conservative (35% equity/65% fixed income) is well suited to those in retirement or who have a shorter investment horizon.

 

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