Sitting in Washington, D.C., traffic the other day made me think of an instructive story I heard some years back. It went something like this: Imagine that you are in your car, leaving Washington, D.C., for a fifteen hour drive to Florida. Unfortunately, half an hour into your trip, you see a line of brake lights ahead and within moments you are sitting still in the middle of a traffic jam. As you stare out the window of your car, you notice people on bicycles flying past you. After an hour of going nowhere, you can’t take it any more. So you jump out of your car, flag down one of the bicycle riders and make him an offer. If he will give you his bike, you will sign over the title to your car and give him the keys right there on the spot. The bicyclist looks at you in amazement and accepts your offer. The exchange is made, and you hop on your newly acquired bicycle and set off on your journey. For a brief moment in time you feel great about your decision. That is, until you get about twenty miles down the road and your legs become as heavy as lead. To add insult to injury, you glance up just in time to watch your recently-traded car go flying by you at 65 mph. You stare helplessly as your car grows smaller and smaller in the distance and soon disappears on the horizon.
This story is a good example of a short-term decision with serious long-term implications. It serves to illustrate a common “bad” behavioral tendency that plagues investors called recency. In case you don’t have your nerd dictionary available, the essence of recency is the tendency in all of us to give too much weight to recent experience, while ignoring the lessons of long-term history.
For an example of the dangers of recency in the financial realm, think back to your feelings regarding investing at the beginning of 2009. To jog your memory, you can pick any headline you want from January 2009, but I will highlight one from Matt Krantz of USA Today on January 2, 2009, that read, Markets’ Fall In 2008 Was Worst in Seven Decades. In the article, Krantz says, “There is no shortage of ways to quantify the destruction. The carnage has been nothing short of breathtaking.”
In case we were a little slow on the uptake and didn’t catch their drift in that article, another headline from the same paper on the same day read, Stocks Close Out Worst Year Since 1931; Dow Drops 33.8% (this article even has a picture of a horrified trader and a handy graphic that lets you track the carnage at 41 different points in the year).
Finding someone who was excited about investing in the stock market in January 2009 was about as easy as finding someone who enjoys dental surgery without Novocain. This in spite of the long term track record of stocks and the fact that investing in stocks is necessary for most investors to achieve their long-term financial goals.
Just like the driver in our opening story, investors were looking for any way out. They weren’t simply sitting still, they felt like they were going in reverse at 100 MPH! Many people traded the ‘car’ of the stock market for the ‘bike’ of bonds and bank accounts at that point in time, and recency was a major contributing factor. Many people have since regretted this decision as they have watched the ‘car’ of the stock market zoom by them as they are pedaling furiously on the ‘bike’ of bonds and bank accounts.
The pull of recency is equally powerful (and dangerous) in good times as well. Think back to the tech bubble of 2000. After tech stocks had gone up for years, it was hard to find anyone who wasn’t excited about investing his or her life savings in tech stocks…right before tech stocks collapsed. It seems that recency is equally effective at triggering irrational exuberance as it is at triggering irrational pessimism. Both are dangerous to your long-term financial health.
To help combat the powerful pull of recency, you should define (and stick to) an asset allocation that will help you meet your short- and long-term goals. You want to monitor your holdings for opportunities to rebalance your portfolio back to your target asset allocation. Rebalancing is perhaps the most powerful tool you have in resisting the pull of recency. When recency tells you to buy more of those investments that have recently performed the best (think tech stocks in 2000), rebalancing forces you to reduce your exposure to those investments. More often than not, recency will cause you to buy high and sell low (not exactly a formula for investment success); rebalancing will help you do the opposite, to buy low and sell high.
So, the next time you are tempted to make a drastic change in your investment strategy based on the recent past, just ask yourself, would I trade my car for a bike because of a little traffic on a long road trip? Of course not. And neither should you trade your well diversified and constructed portfolio for whatever investment has done best recently.