Do You Have a Verb Problem?

Wednesday, October 10th, 2018

Good Morning Relaxing Retirement Member,

Many investors have a “verb” problem!  Do you know what it is?

No, I haven’t turned in my Retirement Coach hat for that of an English teacher.  But, there is a distinction that can lead to problems if it’s not clarified.

Many investors use the word “doing” instead of “done”, and “going” instead of “gone”.

For example, you will often hear the phrase, “XYZ Fund is doing well”, or “ABC Asset Class is going down!”

By themselves, each of these phrases is harmless.  The exception is when they are used as an indicator of what is to come in the future.

When someone says, “ABC Asset Class is going down,” what they are actually implying is two things:

  • first, ABC has recently “gone” down in value, and,
  • second, because it has recently “gone” down in value, it will continue to go down.

In other words, many use it as predictor of what is to come and that’s where the danger lies.

At any point in time, the only thing we can say about any investment is what it has “done” up until now.  “Doing” implies movement into the future.

While it may “feel” as though an investment which has recently gone down in value will continue to go down, and vice versa, the reality is that recent performance of any investment has never shown itself to be an indicator of what is to come next.

There simply is no correlation.

Recency Bias

What I’ve just described is what is known as a recency bias.

Recency bias occurs when we mistake recent events for an ongoing trend, or we use recent performance as an indicator of future performance.

Here are a few examples of this danger:

  1. In 2015, while domestic large cap stocks (S&P 500 Index) earned 1.38%, small caps (Russell 2000 Index) fell (- 4.41%). If it was January, 2016 and you were “evaluating” your holdings in these two indexes with a recency bias, you might conclude that domestic large caps are “doing” better than small caps and decide to remove your holdings in small caps in favor of large caps.

    What you would have then missed out on in 2016 is domestic small cap stocks outpacing large cap stocks 21.31% to 11.96%.

  1. In January 2017, after witnessing small cap stocks significantly outpace domestic and emerging markets large cap stocks in 2016, you may have concluded that small cap stocks are “doing” better, thus leading you to pull from both asset classes to overload in small caps. You then would have missed out on the 37.28% return that the MSCI Emerging Markets Index earned in 2017.
  2. After examining your 2017 year-end returns in January, 2018, you might then conclude that emerging markets are “doing” better than domestic stocks and overloaded in emerging markets at the expense of domestic small cap stocks. Through three quarters of 2018, the MSCI Emerging Markets Index was down (- 7.68%) while the Russell 2000 Small Cap Index was up 11.51%.

Warren Buffet summed it up best when he said, “investors project out into the future what they have most recently been seeing.”

He is so right!

As we have all learned the hard way, there is no correlation whatsoever between recent price movement of a certain asset class of stocks and their price movement over the next year.  Yet, as my examples have shown, how many of us look at an asset class which has recently performed poorly relative to other asset classes and project out into the future that this “trend” will continue?

Or, on the flip side, that a fund or asset class which has shot the lights out this year will continue to do so?

If we want to reap all the rewards that come from capturing market returns, we all have to be very careful of the biases we bring to the table, and the potential negative impact of the verbs we use!

Committed To Your Relaxing Retirement,

Jack Phelps
The Retirement Coach

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(The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)