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Tell Your Clients: Stocks Won’t Go Up Forever

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The human brain is naturally wired to want to invest more in top performing assets and to pull out of assets that have performed badly. This recency bias, as it’s termed in behavioral finance, is always more pronounced at the beginning of a new year.

This year is no exception, said Charlie Bilello, director of research at Pension Partners and manager of the Inflation and Beta Rotation Funds. As in years past, Bilello said, “most investors think that whatever did well last year will repeat this year.”

This year, that means that investors want to put more money into U.S. stocks.

“This happened last year, too, since U.S. stocks had a great year and outpaced their global peers,” Bilello said. “So just as it was at the start of 2014 when investors were thinking that based on 2013’s performance, the S&P would continue to go up, they’re thinking the same thing at the start of 2015.”

The attraction to U.S. stocks is even greater because the S&P has outperformed the MSCI World Index for the past five years, Bilello said. Yet financial advisors know that allowing recency bias to guide investment decisions is not the wisest course of action and can prove completely counterproductive, since the best way to invest is to “keep a mixed and diversified portfolio that can grow wealth over time and to do the opposite of what recent markets have done,” Bilello said.

Steering investors away from their natural tendency to give undue weight to recent market events—positive as well as negative—isn’t an easy thing for advisors to do but it’s important, said Anthony Criscuolo, client services manager at Palisades Hudson Financial Group.

“Investors are calling us up and saying, ‘Why don’t we put more into the S&P 500 and less into international markets and the natural resources market?’” Criscuolo said. “They think that the S&P is going to continue to do great, that the U.S. will keep growing and that the problems in Europe will go on forever, but ultimately, trends reverse, and we need to get our clients to stand back and take a global view of the markets and of various asset classes.”

Because individual investors have a strong emotional tie to their money, advisors need to “emotionally counsel” them to steer away from their emotions in order to “make decisions based on fact and reason,” Criscuolo said. The recency bias typically follows major news cycles—“so you could see it happening in the middle of the year as much as it’s happening right now at the beginning”—but it’s key for advisors to talk their clients through the tendency to be in the moment, he said.

Take energy stocks, for instance. Because of the sharp downturn in oil prices and expectations that they could fall further for a sustained period of time, many investors want to exit the asset class altogether.

“We’re not market timers. Oil prices could continue to stay low and there’s no way to predict that, but what’s important for clients to understand is that their allocation to energy or any other sector is just a part of their overall portfolio. It’s a relatively small piece,” Criscuolo said.

It’s important for clients to understand the role of each asset class within a portfolio, and just because it may not be a top performer does not mean it is not a valid asset class, he said.

To guide their clients away from their recency biases and get them back on the right path, advisors must spend a lot of time educating them, said Bilello. It’s important to make clients understand that they’re not investing for a year or two, but for the longer term. The best way they can do that is to continue to maintain a diversified portfolio because completely exiting one area most likely won’t do them any good.

“Now emerging market valuations are much cheaper so that means that forward returns will also be much better than the S&P, and investors should be encouraged to think further than the next quarter or the next year,” he said.

In fact, while investors have been piling into U.S. stocks, emerging market stocks actually outperformed in January, as did U.S. bonds—an asset class that Bilello believes has been significantly overlooked because of investors’ recency bias toward the stock market.

“Last year we saw U.S. stocks outpacing other stock markets, but looking at 10- and 30-year bonds, they did better than U.S. stocks,” he said. “Investors, though, wanted more stocks and ignored the bond portion of their portfolios. This year, too, almost every strategist is predicting higher rates, so investors are thinking bonds are not a good place to be and focusing all their attention on the stock market.”


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