Academic research into investor behavior has uncovered many behavioral biases that cause investors to make poor decisions, leading them to underperform the very funds in which they invest. My book, Investment Mistakes Even Smart Investors Make and How to Avoid Them, discussed 77 errors investors make that lead to the destruction of returns. Among the most common is recency bias—the tendency to overweight recent events/trends, projecting them into the future, while ignoring long-term evidence.
Performance chasing—buying after periods of strong performance when valuations are higher and expected returns are lower, and selling after periods of poor performance when valuations are lower and expected returns are higher—is not a prescription for successful investing. Yet, because of recency bias, it is what many individuals do. What disciplined investors do is the opposite—rebalance to maintain their well-thought-out allocation to risky assets.
The Causes of Poor Returns
When risk assets have poor returns, it is usually due to a combination of poor performance (falling earnings or producing losses) and falling valuations. Because the best predictor we have of future equity returns is the earnings yield (the inverse of the P/E ratio—E/P), falling valuations mean that future expected returns are now higher. Investors subject to recency bias fail to understand that, leading them to sell instead of buying.
For example, after underperforming one-month Treasury bills from 1929-43, the CAPE 10 fell from 25.3 to just 10.7. From 1944 through 1965, the S&P returned 15.0%, outperforming one-month Treasury bills by 13.2 percentage points per annum. Similarly, after underperforming one-month Treasury bills from 1966 through 1983, the CAPE 10 fell from 19.7 to just 9.8. From 1984 through 1999, the S&P 500 returned 18.1%, outperforming one-month Treasury bills by 12.3 percentage points per annum. And after underperforming one-month Treasury bills from 2000 through 2012, the CAPE 10 fell from 44.2 to 21.2. From 2013 through 2021, the S&P 500 returned 12.6% per annum, outperforming one-month Treasury bills by 11.0 percentage points per annum.
Falling valuations are a “self-healing” mechanism. Similarly, the S&P’s loss of 18.1% in 2022 resulted in the CAPE 10 falling from 38.3 to 28.3. When value stocks underperform growth stocks, the spread in valuations between the two widens. Because the spread in valuations informs future relative returns, a wider spread forecasts a higher value premium.
A good example of the self-healing mechanism at work is that value stocks underperformed by wide margins during the late 1990s technology/dotcom boom. For example, from 1995-1999 the S&P 500 Growth Index returned 33.6% per annum, outperforming the Russell 2000 Value Index by 20.5 percentage points per annum. That outperformance led to valuation spreads widening to historic levels. Over the following eight-year period 2000-07, the Russell 2000 Value Index returned 12.6% per annum, outperforming the S&P 500 Growth Index’s return of -1.7%, by 14.3 percentage points per annum. Over the full period, the Russell 2000 Value Index outperformed the S&P 500 Growth Index by 2.2% percentage points per annum (12.8% versus 10.6%).
Self-Healing Mechanisms Exist in Other Risk Assets
The same self-healing mechanism works with reinsurance. When losses occurred due to the historic fires in California, not only did premiums rise dramatically, but underwriting standards tightened (such that you could not buy insurance if you had trees within 30 feet of your home, and all brush had to be cleared for another 30 feet) and deductibles increased significantly (reducing the risk of losses). Destruction from hurricanes in Florida caused the same combination of events to occur (rising premiums and deductibles, and tougher underwriting standards).
We can see this effect by reviewing the performance of Stone Ridge’s Reinsurance Risk Premium Interval Fund (SRRIX). After three strong returns in its first three years (2014-16) came a string of losses. SRRIX lost -11.35% in 2017, -6.14% in 2018 and -4.47% in 2019 due to more-than-expected hurricanes, wildfires and typhoons. At its inception, the net of expenses “no-loss return” (a yield equivalent of the fund if there were no natural catastrophes in a year, which is unrealistic) was about 13%, and the more realistic modeled (50th percentile) return to investors was about 7%.
Due to the losses and the resulting fleeing of capital, the no-loss and the modeled returns have been persistently rising. As of February 2023, the no-loss return for SRRIX was over 30%, and the 50th percentile modeled return was over 20%. In addition to premiums rising (increasing the expected return), underwriting standards tightened and so did deductibles. Those changes reduced the risks of losses. The result was higher expected returns with less risk. Of course, just as low equity valuations don’t eliminate the risk of losses, the worst one-in-25-year models estimated a loss of about -20%, and worse losses are possible. In other words, there is no risk premium without risk. Those events are what led to the spectacular returns to reinsurance investments in 2023, with SRRIX returning 44.6%. In addition, as we entered 2024, conditions have remained about the same as they were as we entered 2023, with premiums and underwriting standards at high levels. Thus, the expected return (50th percentile) was in the low 20s. Unfortunately, many investors fled and did not earn those high returns. It is likely those investors failed to understand that because premiums adjust on an annual basis, they need to have a long horizon to realize the true economics of the asset class.
Credit Markets are Self-Healing
Equities and reinsurance markets are not the only ones with a self-healing mechanism. The same self-healing mechanism works in lending markets. During periods of economic weakness, investors witness unrealized markdowns in their loan investments and often exit their positions, fearing defaults. What these exiting investors miss is the self-healing mechanism at work through higher credit spreads (coupons), tightening covenants and more rigorous underwriting standards (such as lower loan-to-values) on new loans. An additional bonus for remaining investors is that history shows that subsequent realized losses tend to end up being only about one-half of the initial unrealized markdowns. Subsequent price markups accrue to remaining investors, leaving exiting investors to crystalize the entire markdown.
The 2020-2022 period overlapping COVID-19 provides a good example. Private middle market loans suffered markdowns exceeding 6% in the first quarter of 2020. Fears of future defaults precipitated record outflows from private debt funds. Exiting investors crystalized a 6% loss by selling and for the next two years earned no interest on cash. Remaining investors earned an 18.2% two-year return, including the original 6% unrealized loss. Investor flight proved very costly during COVID-19.
Words of Caution
These are all examples, with the benefit of hindsight, of things working out well. But there was no guarantee of that. This is not riskless arbitrage. And there are extremely long periods where risk assets underperform. One only must look at the case of Japanese stocks, which have underperformed U.S. stocks for 34 years despite valuation spreads widening in their favor in the aftermath of the bubble in Japanese stocks bursting in 1990. It is examples such as this, with risk assets underperforming for long periods, that make contrarian investing so difficult—sometimes mean reversion starts after two to three years and at other times after five, 10 or 15 years, or even longer. This is where the patience challenge gets harder, especially when there are occasions of non-reverting secular trends (which tend to be infrequent), such as the decade-long drift in bond yields.
Resisting recency bias is key to earning the premiums available from all risk assets, including reinsurance. Wise investing, as Warren Buffett noted, is simple but not easy. That’s because of all the behavioral biases investors must overcome, with recency among the most powerful. It’s tempting to sell out of an investment that has suffered losses because it’s easy to think losses will keep happening.
With any long-term risk premium, it’s highly unlikely investors can time entry and exits because it’s simply not possible to know when losses will occur. Getting out of reinsurance now would be the classic “buy high/sell low” strategy—like exiting equities in March 2009, value stocks in 1999 or insurance in 2022. It’s not easy to help investors stay the course, but doing so is a big part of the value advisors provide.
Another important takeaway is that a benefit of investing in funds that invest in a systematic, transparent and replicable manner (such as index funds and other passively managed funds) is that investors can be confident that underperformance occurs because the underlying asset class has gotten less expensive, not because the manager was unskilled (versus merely unlucky).
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.
For informational and educational purposes and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third party data and may become outdated or otherwise superseded without notice. Third-party information is deemed reliable, but its accuracy and completeness cannot be guaranteed. The opinions expressed here are their own and may not accurately reflect those of Buckingham Strategic Wealth, LLC or Buckingham Strategic Partners, LLC, collectively Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. LSR-23-617