Now that a new decade is underway, it’s important to think about the decade that just ended and the lessons we learned about investing – particularly hindsight bias.
Hindsight provides clarity on something that has already happened, like a sudden drop in the stock market or the impact of geopolitical events.
Hindsight bias causes us to perceive events that have already happened as somewhat predictable, even when the reality at the time was much less certain. We all remember positive investing decisions or predictions without considering all the small steps that went right and led to the final result.
So, what can hindsight bias tell us about the debate on active versus passive investment management – especially as it relates to market cycles?
It can remind us that we often become fixated on what has happened without considering what could have happened.
Markets can move in unexpected ways. The current equity bull market is almost 11 years old, so many Canadian investors are preparing for a bear market. During the last major market decline, which took place during the global financial crisis, about 60 per cent of Canadian equity funds outperformed the market.
That has led many Canadian investors to believe that active investment strategies perform better in a bear market. According to this myth, active portfolio managers can move into a defensive position and limit portfolio losses when they see a bear market coming.
Yet, when we look at the last three market cycles – a bull market after the dot-com bust of the early 2000s, a bear market after the global financial crisis in 2008 and the bull market from 2009 onward – we find no pattern to the performance of Canadian-domiciled funds from one investment category or market cycle to the next.
Positioning a portfolio ahead of a change in market cycle is no easy task. After all, most events resulting in significant changes in market direction are unanticipated.
What’s more, to profit from a bear market in the long-run, portfolio managers would not only need to position their portfolios conservatively to protect it from losses on the way down, they would also have to re-risk the portfolio to reap gains on the upside when the market recovers.
A closer look at the data also shows the average Canadian equity fund underperformed in the bull market leading up to the financial crisis before outperforming in the crisis and underperforming again in the bull market that followed.
Global equity managers followed a similar pattern. The average U.S. portfolio manager underperformed in the bull market leading up to financial crisis, outperformed in the crisis and then underperformed again in the subsequent bull market.
Going back as far as 1980 in the U.S., active portfolio managers’ performance over six bear markets was equal to the flip of a coin: the average fund underperformed in three bear markets and outperformed in the other three.
What these data suggest is that investing success isn’t about picking the right active or passive fund manager for the next market cycle – whenever that may be.
Active, passive, or a combination or both investment strategies can work well as long as they’re used in the context of a sound long-term investment plan.
That means having clear goals, constructing a balanced and diversified portfolio, keeping costs low and maintaining a disciplined approach. It also means looking past today’s headlines and building a portfolio to capitalize on all market conditions — whether the bull market we’ve enjoyed for the past decade continues or not.
Predicting the random and surprising events of the past 10 years is difficult. After all, who could have predicted the Toronto Raptors winning an NBA championship or a Canadian winning the 2019 U.S. Open Women’s Singles title?
Luckily, implementing a low-cost, balanced investment approach is much easier and doesn’t require you to predict the future.
Todd Schlanger, CFA, is a senior investment strategist at Vanguard Investments Canada Inc.