Belief drives behavior. The stronger your belief system, the less likely you are to stray from your desired behavior. The converse is also true – the weaker the belief system, the more likely one is to stray from his/her preferred behavior. This is the primary reason why “normal” investors struggle so much, as highlighted by the annual Dalbar study that shows that the stock market has returned 10% per year over the past 20 years while the individual stock investor has returned less than 4% over the same time frame. If your investing belief system is not strong enough, eventually, certain biases (or what psychologists call heuristics) will creep into the subconscious and entice you to make sub-optimal decisions.

There is a “tornado” (see fancy slide here) of heuristics that can wreck a well-designed portfolio, especially when some of these are combined with one and other. Today, I’d like to focus on Recency Bias.

Recency is a cognitive bias that convinces us that new data or information is more important than older data/information. Like many heuristics, many of these “mental shortcuts” can work well in certain circumstances, but they can also lead to systematic deviations from logic, probability and rational choice.

Let’s take the U.S. stock market versus the International stock market as an example. There are some investors who are of the inkling that it makes no sense to invest internationally because:

1. We live in the U.S. and buy things with U.S. dollars¹
2. The U.S. is the biggest, best and most free country in the world
3. The U.S. has the biggest, best companies with the brightest people
4. The U.S. stock market seems to “outperform” the rest of the world every year and probably with less risk.

Let’s focus on the last argument, as this is the crux of this little essay (although, see footnote at bottom as it relates to first argument). The question is: why diversify across the globe if the U.S performs better most of the time? It’d be a fair question if the premise were true. But, is the premise true, or is it a Recency issue? Let’s explore.

I’d love for you to click on the attached slides I worked up here, but I’ll give you the highlights below.

Slide 1: Let’s say you invested $10,000 in the S&P 500 on January 1st, 2010, and you haven’t touched it and let your dividends reinvest (side note, you’re one of about 7 people that were able to “buy and hold” over these last 8 years, but I digress…). At the end of 2017, your $10,000 turned into over $28,000. If – on the other hand – you invested across the globe in a more diversified fashion, your $10,000 turned into about $26,000. Hmm. Maybe this whole diversification thing is for the birds. Maybe, but perhaps eight years doesn’t quite tell us the full story (or, worse, perhaps it tells us the wrong story.)

Slide 2: Let’s go back a little further to Jan 1, 1970. 48 years of data starts to get into the world of “statistical significance” vs a mere eight years of data. Again, you start w $10,000. Fast forward to 12/31/17. Your $10,000 has turned into… wait for it.. a little over $1.2 MILLION! (Oh, great job holding and never panicking and withstanding some small things like hyperinflation of the 70s, gasoline shortages (remember green, yellow and red flags at gas stations in the late 70s?), not one but two assassination attempts on Reagan, the 1987 crash (the equivalent of the Dow Jones dropping 5,750 points at today’s prices), Clinton’s impeachment, the Nasdaq bubble burst, September 11th, the credit crisis and the largest stock market drop since the Great Depression, the Fed’s Balance Sheet, and National Debt and the political climate that we’re in today. I digress…) Anyway, back to the point. How did that same $10,000 invested in fully Globally Diversified portfolio do? I’m glad you asked. You’d have over $4.7 million. Wait, what? Yes, over 4.7 million dollars. (Great job holding during hyperinfla…)

The rest of the slides (again, they are here) may not be self-explanatory, but they’re important in telling the story of the power of diversification over long periods of time. I’d be happy to dig into any of them with you.

The steepest price you have to pay to be fully diversified within stocks (and factors of returns) is the acceptance that we will NEVER have the best returns compared to any one sector or factor or region or asset class or individual stock. This is a price that is no doubt worth paying, as the converse is – once again – also true. And, in the long run, the evidence continues to show that diversification is the closest thing to a “free lunch” in the capital markets, so you might as well get a huge helping of it.

Remember, you have a choice. You can have an investment philosophy or you can have a market opinion. One of these choices helps drive the correct behaviors and superior real-life investor returns, and one of these leaves you open to the whole gamut of behavioral biases and takes a stock portfolio from 10% returns over the past 20 years to less than 4%. Choose wisely.

1  Incidentally, our portfolios do exhibit what is referred to as a “home bias.” We believe it makes sense to tilt one’s portfolio to one’s home country. This is primarily due to purchasing power protection on one’s own currency. As always, don’t hesitate to ask me more.

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