• Stonewood AM

Behavioural Biases: Edition 2 - Recency Bias

by James Twidale

Source: https://www.visualcapitalist.com/five-cognitive-biases-hurt-investors

Following on from last month’s editorial on “Anchoring” and the impact that this has on investors, we are continuing the series of investor behavioral biases and seeing how these impact our investment outcomes.

Today we are going to go through what is known as the “Recency Bias.” This investor trap is fairly easy to explain but the impact on investment decisions is more complex to understand.

So let's dive in. When making a decision we attempt to try and gather as much information as possible before making said decision. When it comes to investing we should try and take everything we can know into account before making the best decision we can make. The people who provide this input from a decision-making perspective are often the investor themselves or the financial advisor of the end investor.

By way of example:

You have R100 000 to invest and now it’s time to decide what to invest in in order to maximize your return while minimizing our risk. Simple, right? You take everything you can into account before making the decision. How have markets performed, what asset classes and investments would have yielded the right return if you had selected them previously? What is happening in the world etc.

Now in truth, I am unsure how many people go through a formal information gathering and synthesis exercise, I would guess fewer than the “rational man test” would assume. So, the question is then what information are we taking into account and how is that impacting our investment outcomes.

Herein lies the hard part. You will by default (because you are human, not because you are stupid) overweight information from the recent past in relation to all information you may know. You are impacted behaviorally most by what has transpired most recently.

This is not necessarily rational. If shark attacks are very rare but the last time you went to the beach you witnessed a shark attack you would naturally overweight the probability of being attacked by a shark next time you go to the beach. You are unlikely to want to swim and that is more a result of placing too much significance on recent events than factoring in the true probability of being attacked.

This bias can be hugely damaging for investors because of the sub-optimal decision making that tends to follow. To add to investor woes, asset class/investments tend to be mean reverting in nature. In other words, if something has recently done well it is more likely to underperform going forward and vice versa.

Am I saying that an asset class that has had an exceptionally good run and entered above-average valuation territory then it is more likely to underperform going forward? The simple answer is YES.

Source: https://dqydj.com/cape-interest-rates-time-future-returns/

The above chart shows the 10-year annualized return of a market dependent on the starting CAPE Shiller P/E Ratio, which is a form of P/E (“Price to Earnings”) valuation ratio. As it stands today, the CAPE P/E is around 30 in the US. Meaning, that if you look at the above chart, future nominal returns are likely to be between 0% - 5% per annum.

That is pretty scary but how is that relevant to my discussion around the Recency Bias?

Well if you had looked at the recent 10-year performance of US equity. You would be very pleased if you had in fact been (and remained invested for the last 10-year period) See table below:

Source: Bloomberg

The above is directly relevant to the “recency bias” discussion. The recent performance of US equity in USD is incredible and if you measure it in ZAR the picture is even more impressive. So with that performance sitting in our minds and memories, it's very difficult to make an investment decision without being tempted to investing a significant proportion of your assets into an asset class that has performed like this.

Our human nature tells us that because US equity has been such a safe bet it would make sense to back this winning horse to continue winning. However, if you look at the contradictory conclusion that the CAPE Shiller P/E chart above depicts it indicates that investing in US equity at this point does not make as much sense.

To be clear we are not trying to make a prediction about the future performance possibilities for US Equity. That investment decision cannot be made in isolation of all other investment considerations. We are simply pointing out that even after reading the logic of this editorial you are still likely to be positively surprised by the performance of US Equity over the last 10 years and tempted to increase your allocation to the asset class.

When you do that just be aware that you are more than likely falling victim to your own human nature in the form of “Recency Bias”.

To avoid this bias there are a few helpful things to consider doing before leaping into your next investment analysis or decision.

  • Understand your investment goals and objectives. This will help you to avoid making decisions that are counter-intuitive in relation to your bigger plan. This is especially important for clients who are approaching or in retirement.

  • Take all asset class return, risk, and valuation characteristics into account before making investment decisions.

  • Make sure you seek the guidance of an investment professional or financial advisor before making portfolio alteration decisions. That is not to say that the advisor or investment professional is not susceptible to “Recency Bias”. They are just as likely to, but their independent oversight may reduce the risk of this happening.

  • Be aware of this bias and ensure it's on your checklist of things to be aware of prior to making an investment decision.

Behavioural biases are receiving far more focus in modern investment advisory and portfolio construction but being aware of these biases is helpful in avoiding value destructive decisions. This week’s bias goes hand in hand with last months “Anchoring Bias” and between these two you can avoid making some painful mistakes.

Until next month...



by Haidee Chiat & Oratile Tlhabane

Source: FactSet

SA equities returned 4.8% after the previous months’ downturn, bringing YTD return to 12.2%. Resources added 10.2% with Gold Mining Companies dominating on the back of high demand for the safe-haven asset and iron ore prices returning close to 60% YTD. Large Cap Equities added 5.4% for the month, which eclipsed the returns of the Mid-Cap and Small Cap universe. Bonds showed a positive return of 2.2%, increasing YTD return to 7.6%.

The South African Trade balance recorded a trade deficit of R6 billion, half the deficit that was seen the same time a year ago, spurred by the rise in exports of iron ore. The economy contracted by 3.2% in the 1st quarter of the year but also recorded an increase in consumer confidence to +5 in the 2nd quarter from +2 in the 1st quarter. Consumer inflation for May rose slightly to 4.5% year-on-year.

Below data showing how the average fund in the different ASISA categories performed, giving an indication of how the average investor’s experience was for the month of June:

Source: Morningstar. Returns longer than one year annualised

President Cryril Ramaphosa delivered the State of the Nation (SONA) detailing a wide range of priorities and goals for the next 10 years and below are few (but not limited to) of those goals:

  • A significant portion of the R230bn that was set aside for Eskom over the 10 years will be made available through a special appropriation bill.

  • The South African Reserve Bank’s (SARB) constitutional mandate was reiterated.

  • The minister of communications was instructed to issue policy direction to the Independent Communications Authority of SA (ICASA), which will enable lower data costs.

  • Implementation of a comprehensive plan to create 2 million jobs for the youth in 10 years.

  • To return an estimated amount of R14.7 billion arising from stolen public money.

Asset classes worldwide saw positive returns in the month of June after optimistic trade negotiations. The G20 summit was held towards the end of June which spoke of fostering global economic growth with specific focus on technological innovation and advancing the African Economy.

Global equities returned 6.6% (in USD$). Developed Markets superseded Emerging Markets for the 5th month in a row. Developed Market’s tech stocks were however negatively affected by US regulators announcing a plan of launching an anti-competitive investigation and despite this, continued new highs were achieved.

Bond markets are pricing in 3 interest rate cuts by the US Federal Reserve by the end of the year which has been largely influenced the increased demand for Global Bonds, returning 2.2%, against the bearish backdrop.

The USD was weaker against all major currencies due to continued trade battle uncertainty (which has subsequently reduced), while the Rand was seen to strengthen as did most other emerging market currencies. The below graph shows the asset class returns for June (in ZAR):

Source: FactSet

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