As any sports fan knows, streaks and slumps are part of the game.
Many believe that a team that has won five games in a row is more likely to win the sixth game than lose it. Fans believe that a basketball player who has been missing free-throws all game is more likely to miss the next attempt. Whether it is teams not winning games (or championships) for years, or star players being either red-hot or sporting goose-eggs on the score sheet, streaks and slumps are part of the reality of sports. But it is also the reality that faces every investor.
The belief that a basketball player is more likely to sink the next basket after a string of hits than after a miss is called the “hot hand fallacy.” It is known as the recency bias, a behavioural bias that affects investors as well. This bias means we place a higher value on recent events than on events in the distant past. In an experiment to analyze investment behaviour, subjects could bet on a series of coin tosses based on the opinion of an expert with a track record, their own opinion or choose a risk-free alternative (in this case, a small nominal payment irrespective of the coin toss result – similar to a cash account in real life). Subjects who relied on the expert chose in line with the hot hand fallacy – picking those who were successful in the recent past. Similarly, a study of Swedish investors saving for retirement found that about 30 per cent displayed classic “return-chasing” behaviour by choosing to invest in the previous year’s best performing fund.
Plenty of research supports the view that investors form future expectations based on recent experience. For example, individuals who had recent investment gains increased the amount they contributed to their retirement savings. Similarly, investors’ prior experience in investing in new equity offerings was a key predictor of similar behaviour in the future.
What the research and actual investor experience suggests is that investors tend to buy stocks that have recently gone up in value and avoid stocks that have recently lost in value. That is admittedly a simplified, but broadly accurate, summary of the impact of recency bias on investor decision-making.
However, the impact of these decisions on long-term portfolio performance can be significant. Two recent studies suggest a few implications that investors should consider in their investment decisions.
The first study considered equity market returns in more than 70 countries over the past 200 years and found that securities with high returns over the past three to five years tend to underperform in the following years relative to securities with low returns through the same period. In other words, past high returns reverse over the long-term to negative returns and vice versa. The researchers found that the momentum of past high returns was sustained for about another 12 months but then subsequently reversed and was fully erased in the following two years. This long-term reversal pattern was observed across all time periods and countries, but it should be noted that the researchers found that this effect can disappear for periods lasting decades, something that they concluded applies to our recent experience.
The second study looked at U.S. stock market data from 1926 to 2016. Analyzing stocks with the highest returns over the previous month, the researchers found they underperformed stocks with the lowest returns by 1.2 per cent in the subsequent month.
Taken together, these results put added value to investment companies’ warning that “past performance is no guarantee of future results.” Over the long term there is a reversal pattern of equity market returns – sometimes, as in recent years, it takes longer for that reversal to take place.
What can investors do? A few things. First, investing for the long term is even more important in the face of these patterns of reversal. Similarly, investing in a diversified portfolio is critical to ensure that the portfolio is insulated from the negative impact of reversal. Finally, a disciplined process of rebalancing the portfolio is highly recommended. Rebalancing is the process of regularly, usually annually, selling the strongest performing asset classes and buying the weakest performing asset classes to bring the portfolio back in line with the long-term investment plan. This is counterintuitive and requires investors to reduce their position in winners and add to their position in losers, pay taxes on gains, etc. But, if done as part of a disciplined long-term investment strategy, and at the level of asset class rather than individual security, it can protect portfolios from this reversal effect. After all, streaks always end – whether in sports or in portfolios.
Sam Sivarajan holds a doctorate in behavioural finance and has led wealth management teams at several of Canada’s largest financial institutions.He is the author of Making Your Money Work: The Secrets to Financial Health and Uphill: How to Apply Ancient Wisdom and Modern Science to Life’s Choices and Challenges. For more information, visit www.samsivarajan.com.