This tool can help investors see the perils of performance chasing.
This month's article is the 20th in a series called "Behavioral Finance and Retirement," which is intended to provide insight to advisors on the unique needs and financial behaviors of clients who are entering that period of transition called "retirement."
I put retirement in quotation marks because people today are not retiring the way they used to. The days of the retirement party, the gold watch, and sitting out one's years doing crossword puzzles and watching "Wheel of Fortune" are over for most people.
We've all heard the analogy that the baby boomers are like a baseball going through a garden hose. Well, the baseball is getting to the end of the hose, and it's not leaving without a bang! And before it leaves, it will be a financial force to be reckoned with.
To serve retired clients properly, there are some key themes that advisors need to be aware of:
1. People are living longer than ever thanks in part to medical technology and better living habits such as diet and exercise. This is extending the length of time people are in a nonworking phase of life.
2. People's definition of retirement is changing, which is having a major impact on how individuals manage their finances.
3. In some cases, a certain segment of the population will have no choice but to produce some type of income after they leave the traditional workforce.
4. The responsibility of planning and investing for retirement has shifted in large part to the employee/retiree and away from corporations. As a result, behavioral biases significantly affect individuals who are entering or already in this phase of life.
In this article we are exploring another bias that affects the retirement planning process: recency bias. An information processing bias, recency bias occurs when people more prominently recall and emphasize recent events and observations than those that occurred in the more distant past.
Humans have short memories in general, but especially when it comes to investing cycles. Consider the following: Suppose that a passenger is peering off the observation deck of a cruise ship and spots precisely equal numbers of green boats and blue boats over the duration of her trip. However, if the green boats pass by more frequently toward the end of the cruise, with the passing of blue boats dispersed evenly or concentrated toward the beginning, then recency bias could influence the passenger to recall, following the cruise, that more green than blue boats sailed by.
This phenomenon also happens frequently in the minds of investors.
Investment Implications for Retirement Planning
One of the most obvious manifestations of recency bias among investors pertains to their misuse of investment performance records for mutual funds and other types of investments. Investors track managers who produce temporary outsized returns during a one-, two-, or three-year period, and then make investment decisions based only on such recent experiences. Often, manager returns revert to the mean and then underperform in subsequent periods.
In a financial planning context, an advisor may come across a situation in which a retiree may be "behind" in savings and may wish to "catch up" by investing with a manager that has performed well recently. In other words, the client is chasing returns. Often this leads to poor results because no one outperforms forever.
As many wealth managers know, recency bias was rampant among investors during the bull market in U.S. real estate between 2003 and 2007. Many investors implicitly presumed, as they have during other cyclical peaks, that real estate would continue its enormous gains forever. They all but forgot the fact that bear markets can and do occur.
Bring Some Perspective to the Table
To counteract the effects of the recency bias, many practitioners wisely use what has become known as the "periodic table of investment returns," an adaptation of the scientific periodic table of chemical elements put together by investment consulting firm Callan.
Because many investors do not pay heed to the cyclical nature of asset class returns, funds that have performed spectacularly in the very recent past appear unduly attractive. If you look at the table, you'll see that often the best performing asset classes in one year or two years in a row are at the bottom of the table in subsequent years. This is the nature of investing.
Asset classes can go from being priced at a "fair" value to becoming overvalued, undervalued, or anywhere in between, just like a pendulum swinging from one extreme to the next.
Investors need to maintain discipline in order to achieve their financial goals. Using the table is a very good technique for getting clients to stick to a plan and achieve their long-term investment goals.