The Problem with Perceived Performance
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May 19, 2017
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May 26, 2017
When it comes to movements in the stock market, many investors want to believe that they can predict the future. They are tempted to switch asset classes based on perceived predictions of future performance, but the reality is that very little about the stock market can be accurately predicted.
One reason investors believe they can predict the future is known as recency bias. Throughout daily life everyone relies on habits- what was done yesterday is done in the same way today. Relying on the most recent experience as the basis for understanding what will happen in the future leads people to make decisions that might not be made under different circumstances.
In the world of investing, this type of thinking can cause problems. When there is a bull market, recent memory tells investors that the market will continue increasing. Therefore, buying increases under the assumption that the market will do what it has done in the recent past. Unfortunately, sometimes the market falls, leaving investors feeling shocked that they did not see it coming.
Similarly, when the market is down, investors become convinced that it will not rise again and stocks should be sold. Letting yesterday’s market be the only determining factor in future investment plans is not the most prudent way to approach an investment strategy.
The image below shows annual ranked performance of major asset classes in the US and International markets from 2002-2016. The asset classes are then represented by corresponding market indices. Notice that there is no pattern in the data, showing no obvious patterns of performance across asset classes. This suggests that predicting the future performance of investments is pretty near impossible.
However, the charts do show additional evidence of market efficiency, making a strong case that investors should rely on the structure of their portfolios rather than market timing. Pursuing returns should be based on trusting the structure of what has been built, instead of the hard-to-keep promises of bigger and better things in the future.
