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Last week, Bank of Canada Governor Stephen Poloz flipped on his recent bias that the Canadian economy was strengthening – though he does expect a second-half bounce back from the Fort McMurray wildfires.

"Recency bias" is a psychological phenomenon where people overweight more recent events compared to longer-term trends when making decisions. The "data dependency" policy of the U.S. Federal Reserve is a form of recency bias, rather than focusing on longer-term trends. This bias has kept the Fed on the sidelines all year having had an expectation for four rate hikes this year when they started last December. Does the tendency toward recency bias support the notion that central bankers cannot forecast longer-term trends or is it something deeper?

Central bankers seem to be more swayed by recent events than longer-term trends. This tends to make policy making an exercise in looking in the rear-view mirror. It's much easier to defend a position in front of Congress and investors if all can see the "reason" why. This has, over the years, led to a myopic focus for governing monetary policy: Central banks are trying to micromanage the natural ebb and flow of the global cyclical economy – they are at the mercy of Mr. Market more than ever in history. We likely need more of Adam Smith's invisible hand and less do-whatever-needs-to-be-done monetary policy. European Central Bank president Mario Draghi's statement this week that the ECB did not even consider more accommodation might be an eye-opener and a message to Brussels that abundant fiscal policy (even more debt) is the next step because he is running out of qualifying bonds to fill his quantitative-easing program.

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If investors were all perfectly long-term rational thinkers and less myopic, everyone should theoretically have 100-per-cent equity portfolio allocation. When you consider that the long-run historical return of diversified global equities (developed market) is close to 8 per cent a year (since 1969), having a long-term perspective should be intuitive – but it's rarely viewed that way despite most advisers recommending long-term planning.

The vast majority of people get caught up in the stress of market noise and very few can handle the true cost of investing for the long-term – volatility. Accepting volatility is the cost of achieving the average long run return. The cost of this long-run 8-per-cent return since 1969 was being able to handle 14-per-cent annual standard deviation. That means while the average return was 8 per cent, the range of returns was about plus 36 per cent to minus 20 per cent with several peak-to-trough drawdowns closer to minus 50 per cent. It's the downside outliers such as the swift 1987 crash, the 2000 tech bubble bursting (exacerbated by 9/11) and most recently the 2007-09 Great Recession that make the heart palpitate and cause most to take their eyes off the long-term goal. When we consider return and risk at the same time, we call this risk-adjusted returns. Over time, you should look at the average return divided by the standard deviation of that return, or what is called the Sharpe ratio, to determine whether you can handle the ride you need to take to get that return – anything less is foolish.

Where you measure that average return from is critical. If you measure the long-run return from August, 2000 (2.8 per cent), or August, 1987 (5.95 per cent), you get a very different average return with more volatility (an extra few percentage points annually). Conversely, if you measure that average return and volatility after the declines, your risk-adjusted numbers are significantly more impressive. So where you start and where you end is the most important consideration for investors who take a long-term approach. Considering that the MSCI world index is at an all-time high led mostly by the U.S. markets, that average return in the future is likely significantly lower with higher volatility – at least for the next few years.

If we measure the annualized total return for the S&P/TSX composite from May, 2008 (when oil peaked above $140), the number is a paltry 1 per cent with 14-per-cent annualized volatility. If we measure that from February, 2009 (when oil last hit $30), the average return is 13.9 per cent with 11.4-per-cent annualized volatility. So anyone who tells you time in the market is more important than timing the market is misguided, because the facts cannot be disputed. The difficulty, as in recency bias, is that we tend react after the fact and not before. Most do not rebalance portfolios until the markets have already caused them some emotional stress. The facts are simple in this regard: You need to be more in equities near low points and have less exposure near high points.

The rub to this whole thing is that we have to be able to forecast when to best take advantage of it or suffer from recency bias. In 1999, markets went from overvalued to stupidly overvalued in 2000 before greed turned to panic and Nortel that was about 35 per cent of the S&P/TSX at the high withered to worthless a few years later.

Taking a long-term view is the correct approach for central bankers and for investors – but you have to be able to handle the ride. It is clear that central bankers are even more myopic these days. If the Federal Reserve does not raise rates this month (I think they will: As of this writing, odds are 38 per cent up from 22 per cent before Mr. Draghi's comments), they may not get the chance for several years as equity market expected returns for the next decade are likely to be weak because we are now measuring from a very high point looking forward.

Larry Berman is co-founder of ETF Capital Management. He is a Chartered Market Technician, a Chartered Financial Analyst charterholder, and is a U.S.-registered Commodity Trading Advisor.

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