Nov 15, 2021 | BEN WAITE
Any driver out there knows you can’t be behind the wheel and constantly looking in the rear-view mirror. Of course, you need to check it every now and then, when the circumstances are right but ultimately, it’s not the main factor in helping you reach your destination.
The same goes for investing.
Simply looking at what’s happened in the recent past isn’t going to set you up for the future and ultimately could become a costly distraction.
Let’s look at why that’s the case…
In recent years, UK and emerging equity markets, global commercial property, value and smaller company stocks have all fared poorly in comparison to larger companies in overseas markets, particularly the US.
We’ve blogged about the big tech companies before and how they’re holding up in comparison to the rest of the US market – if you made the decision to invest purely on what’s been happening recently you’d be taking a concentrated bet on those companies.
In addition to this, the future growth expectations are already captured in today’s stock prices – you’d be buying high and that’s a recipe for a potential disaster as these companies would need to perform better than expected for prices to rise further.
In finance, behavioural psychologists call this rear-view mirror investing or recency bias – where investors make decisions influenced by recent market movements.
Markets throughout the decades
The chart below illustrates how dangerous the recency bias can be.
You can see that all the different parts of a diversified portfolio wax and wane over time. At the end of the 2000s, the rear-view mirror investor would have avoided the broad US and world developed markets, yet in the following period of the 2010s they were exceptionally strong performers.
Equally, investors who succumbed to recency bias and bought into the emerging markets at the end of the 2000s would’ve seen these investments underperform in the following decade.
What does this mean for me as an investor?
– Don’t put all of your eggs in one basket – in particular the basket which has recently performed the best! No-one knows what the 2020s will bring and diversification is your only free lunch.
– Take a highly diversified approach with your portfolio and don’t forget about exposure to some of the riskier parts of the market – including smaller/cheaper companies and those in emerging countries. If part of your portfolio isn’t performing relatively poorly compared to the rest, you’re probably not diversified enough!
– Rear-view mirror investing just means you are buying investments at high prices and when they subsequently begin to underperform, you’re more likely to sell them to reinvest in the next recent high performer. Buying high and selling low is definitely a losing investment strategy and dangerous for your wealth.
– A long-term approach is critical. It can take time for investment returns to come through. If riskier assets guaranteed a return, there would be no risk in the first place and returns would be the same as assets such as cash.
– In an environment where cash delivers a negative return after inflation, and the expected returns for both bonds and equities are reduced as a consequence, the incremental returns of riskier assets are not to be sniffed at.
Keep moving forward
Don’t waste time looking back and wishing you’d owned a different portfolio. Take comfort from the fact that you own a highly diversified and soundly structured portfolio that gives you every chance of a successful outcome in an uncertain, forward looking world.
This communication is for general information only and is not intended to be individual advice. You are recommended to seek competent professional advice before taking any action.