In this quarter’s letter, I keep thinking about the difference between familiar and normal. In so many areas of our lives, the normal has given way to the familiar. What was once not normal has become familiar, ie. wearing masks, schools and restaurants closing, hand-washing stations. Also, the opposite is true that what was once normal is not so familiar now.
So how does this affect our planning? Well, in several ways (which is why I thought it was such an interesting article subject). One way is through the study of behavioral finance and how investors make decisions using our inherent biases which are separated into two distinct areas, Emotional and Cognitive Biases. Emotional biases come from the emotions we feel when preparing to make a decision. Cognitive biases identify the logical thought process.
Emotional Bias
Status Quo: An investor is predisposed (when faced with an array of options) to select the option that keeps conditions the same or familiar. Saying all else is equal doesn’t change from the current environment. As we all know, this can be a significant issue, as the only true constant is change. This “resistance to change” can lead to a lack of diversification in a portfolio, realizing mid-course corrections in light of new planning goals, not updating beneficiaries on insurance policies…and certainly leads to other biases like overconfidence, the illusion of control, and endowment bias.
Cognitive Bias (logical, non-emotional)
Recency Bias: When an investor looks at recent market returns while making critical financial decisions. Again, normalizing what is familiar and not remembering context. This bias can lead to chasing performance and overlooking long-term thinking for short-term results. Not a great strategy in 2001, 2009, 2014, 2018, and 2020. Of course, if you stuck to your long-term plan, your portfolio likely rebounded to bigger and bigger highs, but not without discomfort or unnecessary risks. It may have even changed your retirement plan or date if you happen to be in the early years of retirement. Significant losses or volatility in the early years can drastically change your income modeling or sequence of return risk.
Both of these biases come from a place of fear – fear of making the wrong mistake, of missing out on significant investment returns, of change, or even of acknowledging change. Sometimes we drown out those things that may be uncomfortable or foreign for the soft pillowy comfort of the known.
Some context: Normal v. Familiar
Ending in October, the past 10-year average return of the SP500 was 14.41% / year. However, the last 30 years averaged only 9.145%. That’s a 36% difference! I would argue that the 30-year number is normal, and the 10-year number is familiar. If you want to check my math, here is the link: https://www.macrotrends.net/2526/sp-500-historical-annual-returns
On a side note, YTD Return for SP500: 22.61%
This exposes the systematic ups and downs in the capital markets, specifically as it relates to investment returns. Stocks do not go up in a straight line, and “reversion to the mean” is a real thing or normal. In the past ten years, fewer ups and downs created significant outperformance over the average, which has become familiar.
This is not a doom and gloom letter on the contrary. Investing for long-term growth is a significant factor in the success of a financial plan, but we need to maintain a sense of history. Taking all these factors into account can ONLY help your decision-making process. However, for newer/younger investors, this may be a tough lesson, as many have never seen a correction and have been living their entire investing lives in perpetual bull markets.
As Adam Smith wrote in “The Money Game” (1960):
“Memory can get in the way of such a jolly market, that malaise that comes with the instantly gone, flickering feeling of déjà vu; we have all been there before”.
Experiencing soul-crushing volatility is a rite of passage for any market participant, but misidentifying the familiar for the normal can be a costly mistake and can undoubtedly be avoided. Experienced investors need to remember the days before Facebook and the amount of stress they experienced in the bear markets of 2001, 2008, and 2018. Are changes required? I don’t know, but being aware of your biases can help you make better decisions.
One truth remains: there is still no replacement for a well-thought-out, a long-term financial plan created in partnership with a trusted advisor.
What I am watching:
- Holiday demand: There are a lot of boats sitting off Long Beach, many of which are chock full of Christmas goodies just trying to get to our grubby little hands. I am supremely interested in how this will play out. Consider declining supply, an already inflationary environment, and fast-growing GDP. Let’s say I’m getting my Christmas shopping done early.
- Biden tax plan and the infrastructure bill. Is there a more powerful person in the US at this moment than Sen. Joe Manchin? See what happens when both parties hate but need you.
- Municipal Bonds (California): How will tax legislation affect the supply/demand of Tax-Free California municipal bonds?
- When will Yellowstone come back on TV?
As always, please contact me directly if you have any questions. I can be of assistance to you or someone you know.
Philip Clark, CPWA®, CFP®, CLU®| Director – Wealth Management
Direct: 626.788.3947
This information should not be construed as tax advice, nor should be taken as financial planning advice. Please consult your tax professional. These opinions are based on observations and research and are not intended to predict or depict performance of any investment. These views are as of the close of business on 11/03/2021 and are subject to change based on subsequent developments. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. These views should not be construed as a recommendation to buy or sell any securities. Past performance does not guarantee future results.