Outside-IN

Recency bias: A big risk to your clients this summer

With market volatility picking up in 2018, explain to clients that markets aren't serially correlated and shouldn't inspire fear or actions that jeopardize long-term goals

Jul 10, 2018 @ 3:48 pm

By Damian Ornani

It is perhaps the most oft written sentence in investing: Past performance is never an indication of future results. Lots of people tie this to disclosures on materials and relate it to an individual manager's results. But it is bigger than that.

It is a (perhaps legalistic) reminder: Markets aren't serially correlated — past movement, recent or distant, doesn't predict the future. Following a volatile back-and-forth start to 2018, I suspect some of your clients need a reminder of this now, helping keep them on track toward their long-term goals and needs.

2018 has been a choppy year, generating meager overall returns. The S&P 500, for example, began 2018 with a stock market correction — a short, sudden, sentiment-driven drop exceeding -10%. Between January 26 and February 8, the S&P 500 fell -10.1%. Moreover, in this year's 113 trading days, the S&P 500 rose or fell by more than 1% on 35 occasions, or once every 3.2 days.

(More: Volatile trading in first half upends expectations)

This is in sharp contrast to last year's uncommon lack of volatility. Nothing approaching a correction occurred. Stocks rose or fell by more than 1% only nine times all year! That is once every 27.9 days. That smooth ride last year accompanied full-year returns of 21.8%. This year's bouncy trip? Through June 13, stocks are up 4.7% year to date.

While that isn't anything to scoff at, given the backdrop, some clients may wonder if the volatility is worth it. Many likely see the past six months, feel the volatility acutely after last year's calm, and extrapolate the tepid returns and big swings forward. This is natural, a behavioral tendency called "recency bias." But it can lead to errors, like selling due to past market movement.

This tendency is also why many investors were hyper-bullish at the height of the 1999–2000 technology boom, extrapolating fast-rising stock prices into the future and failing to fathom the fact the direction could reverse.

Similarly, in early 2009 — the depths of the bear market that accompanied the global financial crisis — the steep drops and huge negativity had few expecting anything positive for markets. What followed was a typically strong beginning to the bull market I believe presently continues.

Today's sentiment and market conditions don't seem nearly as extreme as these examples. But given the choppy market and fears over interest rates, inflation, politics, trade wars, a few problems in select emerging-market nations and more, it isn't hard to see how clients could deviate from their retirement plans.

This is an opportunity for good advisers to help their clients — a time to offer counsel, educate and prove their worth.

Start by empathizing. Make sure clients know you are on their side and understand that this year feels markedly different than 2017.

Then remind clients markets aren't serially correlated: How 2018 began doesn't mean that is its path forward. Use my two extreme examples, if you wish! Or use any of the stock market corrections during this bull market. Or find two of your own — there are countless options.

But more importantly, remind clients with stock market exposure why they have it in the first place. I doubt it has much to do with the coming six months — and nothing at all to do with the last six. Stock investments, in my view, are all about harnessing long-term compound growth — what Albert Einstein famously called "the eighth wonder of the world" — to meet needs later in life. Even clients in retirement may have 10, 20 or 30 years to fund. Missing positive returns — including just a small amount like 10% — can snowball due to compounding's exponential impact.

So do your clients a service: Coach them not to let recent market movement affect their view of the future.

Of course, it is possible something has changed in a client's goals or needs. You will have to explore that, too. But if you aren't reminding your clients of the risk behavioral tendencies like recency bias pose to achieving the results they want or need, I believe you aren't serving them optimally.

Damian Ornani is CEO of Fisher Investments.

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