Investment Trends Are Fleeting: Defending Against Recency Bias

Jeff DeMaso:
In the midst of a global pandemic, tech stocks are soaring, interest rates are in the basement, and gold has made a comeback. Investors are wondering if this time truly is different. Join me and Dan Wiener as we look at recent events, recency bias and some of the strategies that investors believe have been turned on their heads.

Dan Wiener:
Hello, and welcome to another The Adviser You Can Talk To Podcast, I’m Dan Wiener, chairman of Adviser Investments.

Jeff DeMaso:
And I’m Jeff DeMaso, director of research here at Adviser Investments.

Dan Wiener:
You know, Jeff, recency bias is real. Recency bias is that tendency we seem to have to expect that the future is going to look a lot like our most recent past. We’ve seen a lot of that recently. If it’s been raining and raining for days on end, well, we expect it to keep raining. If we’ve had a good run of luck at the casino’s blackjack table, it seems to be our expectation that our next hand will also be a winner. Recency bias seems to happen a lot in the investment world. And boy, you and I were talking just the other day about how we were seeing this happen across a number of different asset classes.

Dan Wiener:
If stocks are going up, investors tend to expect them to keep going up at the same rate. If junk bonds are having a terrible month, well, naturally people expect that that under-performance is going to continue. I think, though, that smart investors know when they’re being manipulated by their own recency bias. So, let me ask you a question. You run a very tight ship here at Adviser Investments on the research side and your team has pretty much seen it all and heard it all and done it all. What do you make, speaking of recency bias, of this conversation that I think started in The Wall Street Journal the other day that the benchmark 10-year Treasury note is no longer a benchmark, that it simply can’t be relied upon as an economic indicator, and by extension, it’s an indicator of investor fear of bravery, that’s gone out the window. What are the implications if that’s true, but do you think it’s true to begin with?

Jeff DeMaso:
Short answer is no, I don’t think it’s true. I think the 10-year Treasury is still very much a barometer of the economy and investors psyche, although maybe it’s just not giving an answer that people want to hear.

Dan Wiener:
Well, it certainly isn’t giving them the yield they want to see, that’s for sure.

Jeff DeMaso:
No, it’s not. And I think that’s a good point, it’s the yield that really has people on edge. I mean the 10-year Treasury has been yielding, let’s just say, around 0.6. I know it jumped up a bit yesterday, two weeks ago it hit a new low of around 0.508. But let’s dive into that article. There were three pieces or three qualities to 10-year Treasurys that they identified. And the first one you mentioned was, quality as a window into the economy. And if we look back over the last 60 years, there’s a pretty good relationship between the yield on the 10-year Treasury and GDP growth. That correlation is about 0.6. Correlation is just a technical term for how related two pieces of data are over time. Perfect strong correlation would be one, zero would mean that they just moved totally independently of each other and a negative one means they move in opposite directions all the time. So 0.6 is pretty strong.

Dan Wiener:
You think 0.6 is pretty good correlation? I mean, it’s still just 60% really.

Jeff DeMaso:
Yeah. I mean, look, it’s not perfect. Rarely are things perfectly correlated. It means that there’s going to be times where they’re different. I mean, we just saw in this quarter, I said the 10-year Treasury is yielding around 0.5 and we know GDP fell around 9% or 10% from the prior quarter. So there are divergences and you’re going to see it diverge in the year ahead as well because GDP, we know if we just rebound a little bit coming off of that low base, is going to show some nice year over year percentage gains. Even if that is just getting back to where we were.

Dan Wiener:
Okay, so the idea that the 10-year Treasury is not a good indicator of economic growth, that’s wrong.

Jeff DeMaso:
It’s wrong. And again, I think it’s telling us that growth is going to be slow going ahead, and maybe that’s not the answer people want.

Dan Wiener:
How about Treasurys, and the 10-year Treasury being the benchmark, of course, how about it not being a good hedge for falling stock prices? I mean, that’s one of the other big claims, it’s no good anymore.

Jeff DeMaso:
Oh man, we’ve been hearing this one for years. I mean, yields have been low, maybe not as low as they are today, but they’ve been low for years and years. And everyone keeps saying that bonds won’t be as good a buffer when stock prices fall. Well, you don’t have to go back too far to get a great example of how this claim that they don’t work anymore is just false. At the end of February, the yield on the 10-year Treasury was 1.13%. That sounds pretty low to me. We know stocks fell by a good margin in March, down 10%, 15%, 20%, depending what stocks you’re measuring. And yet, Vanguard Intermediate-Term Treasury returned about 3% in March.

Dan Wiener:
So, you do get some protection from Treasurys, no matter what the yields. Do you think that this reaction, this article, the investors feeling that 10-year Treasurys no longer represent a good benchmark for either the economy or a benchmark for investors is due the fact that yields have been particularly low for a while. They’ve been under 0.6% now for a couple of weeks, they hit a record low the other day of 0.508%. I remember when Treasurys fell below 3% yields and people said this is the end of the world as we know it.

Jeff DeMaso:
Absolutely. The tendency here is again, that recency bias of yields being below 0.6% or below 1%, whatever you want to call it, and just extrapolating that out forever and assuming that they’re always going to stay this low, and the concern is that investors aren’t going to get a high level of income without taking on risk. And that’s fair for where we are today. Treasurys aren’t paying you as much income as they were before, and that’s just the reality we have to try and deal with. But that doesn’t mean it can’t still tell us some insight into the economy. It can’t still be an effective diversifier in a balanced portfolio.

Dan Wiener:
But even though Treasurys are paying a very low yield, inflation’s very low too, right? I mean, I know a lot of investors like to look back at the ‘80s or they look back at the ‘90s and they say, “Gosh, Treasurys, the 10-year Treasury was paying 18%.” I remember getting 18% in one of my money market accounts in the ‘80s, but inflation was running like crazy then, and if you adjust for inflation, I don’t believe actually that even the ridiculous sounding yield of 0.6% looks that bad relative to inflation today.

Jeff DeMaso:
No, you’re absolutely spot-on there, Dan. Relative to inflation or looking at the “real yield,” Treasury yields look in line with history and where they’ve been.

Dan Wiener:
Okay. So, I’m going to jump ahead here because on that same note, and again, recency bias, the bias toward believing that what’s happened recently is going to happen in the future, there’s another investment benchmark that’s been taking a lot of heat lately. In fact, you and I have been trading articles and talking about this death of the 60/40, or the policy portfolio, the standard balanced portfolio which, by a strict definition, is 60% allocated to stocks and 40% in Treasury bonds. What’s the argument there?

Jeff DeMaso:
Yeah. Actually, before I get to the argument, what just occurs to me, in addition to recency bias, let me just quickly point out that these are headlines and the media isn’t necessarily out to educate and inform investors as best they can, it’s to get people to click on articles. And which story sounds more click worthy to you? “The death of the 60/40 portfolio” or a headline that says, “An investment approach that has worked for 80 years will probably keep working.”

Dan Wiener:
Right.

Jeff DeMaso:
Right. Okay.

Dan Wiener:
Now, we’ve taken our swipe at clickbait, let’s go on.

Jeff DeMaso:
All right. So, 60/40 portfolio. What’s the argument here? What’s the concern? Well, it relates very much to those low yields we’ve been talking about. So, a bonds yield is a good predictor of its return. A bond mutual funds yield is a good predictor of its return over the next five, seven, 10 years. So, the concern is that today, with bond yields very low, Vanguard total bond market index is currently yielding a little bit over 1%. That if that’s our expectation for returns out of bonds, around 1%, well, then do you really want to have 40% of your portfolio in bonds? As we’ve discussed, you don’t just own bonds to generate return, they’re there to provide balance in your portfolio, they’re there to protect you when stocks go down. If you’re looking at-

Dan Wiener:
Right, they’re the shock absorber for these crazy stock moves like in March.

Jeff DeMaso:
Exactly. We know that investing in the stock market’s the best way to grow your wealth over time, but it’s comes at a high price of volatility and big draw downs and not everybody can handle that. And that’s fine, but bonds still serve that shock absorbing role.

Jeff DeMaso:
Another pet peeve I have with all these “death of 60/40” articles is that they never provide a good alternative to bonds, they always say you should buy MLPs or REITs or convertible securities-

Dan Wiener:
Or buying dividend stocks, which seems completely ridiculous. Adding more stocks to a stock portfolio just because you think the dividend is going to protect you.

Jeff DeMaso:
Totally agree. And we know that dividends are nice and they provide income, but they don’t provide the same shock-absorbing capabilities as bonds. So, again, if you’re building a diversified portfolio, they’re still very much a role there.

Dan Wiener:
So the historical return on a 60/40 is 8%, 9%, 7%. Can we look for that in the future or are these 1% bond yields going to pretty much throw that out the window?

Jeff DeMaso:
Well it doesn’t throw it out the window entirely. If bonds are going to return one, 1.5%, to hit 8% return for a balanced index, stocks will need to return 12% to 13% a year. That’s a healthy return from stocks.

Dan Wiener:
I would say.

Jeff DeMaso:
It’s certainly within the realm of history though. My advice or thoughts on that would be, it’s possible we could get that historic 8% return, but maybe don’t have that be your baseline expectation, maybe expect returns to come in a bit lower than that, and prepare for the worst, but be positioned for some pleasant surprises.

Dan Wiener:
Well, it’s also, if you’ve been in a balanced portfolio lately, you’ve beaten your expectations. So, with bonds having produced returns hitting well above their average and stocks doing the same. So, maybe it, again, is just getting back to expectations.

Jeff DeMaso:
I think so. So let me toss a question over your way, Dan, as it’s getting harder and harder to do an investment podcast without talking about tech at some point. Tech’s been rallying very hard this year, but for years as well. Making it a classic example of recency bias, if you ask someone what’s done well, they’re probably going to say tech, and they might even name some specific stocks like Facebook, Apple, Amazon, to name a couple. So everyone and their brother wants to load up on tech stocks because they’ve been so strong recently, do you think this is a bubble? Are things different compared to the last big the rally?

Dan Wiener:
People are just chasing what’s doing well. Right? The tech stocks have been just blowing the doors off everything else, and so everybody wants to load up on them. So, first of all, let’s get on the statistics here. Five stocks, five tech stocks make up 20% of the S&P’s capitalization, Microsoft, Google, Apple, Facebook, Amazon. So those five companies have been driving the stock market lately and investors have been driving them, but even more critically, look at the NASDAQ, the NASDAQ Composite index, there are something like 2,700 companies in that index, and yet, those five companies I just mentioned, Microsoft, Google, Apple, Facebook, Amazon, they represent 40% of the NASDAQ index. And of course, the NASDAQ is up 20% this year, kind of incredible. So, recency bias, the bias of investors today is, “I want everything at the top of that Index. I want all five of those companies.”

Dan Wiener:
So, is it a bubble? I don’t know. Work from home is still a strong trend and of course, work from home means that people need more technology, they’re going to continue to use that technology as they work from home. You’re hearing about people starting to go back into their offices, but they’re like ghost towns. So, home offices are going to become, and will continue to be, a strong source of demand for the tech companies.

Dan Wiener:
That being said, there’s no reason you couldn’t see a rotation to other parts of the economy if the economy begins to recover or continues to recover from this recession that we’re in. There will be companies in the tech sector that are going to survive, there are going to be some that will not. I still think, and you can hopefully back me up on this, diversification is key. I remember a period not too long ago in tech stocks were hot during the bubble in the late ‘90s and early 2000, and boy, investors really got out over the tips of their skis. They loaded up, loaded up, they forgot all about valuations, they forgot about the benefits of diversification, and they got hammered. So, the recency bias that says, “I want to load up on tech because tech is doing great right now.” I would just caution investors that they need to remain diversified, the time will come when tech will lag, and then all this bias toward tech is not going to look very good in your portfolio.

Jeff DeMaso:
100% back you up on that. Can’t let recency bias take you away from solid investment principles.

Dan Wiener:
So, I got one more recency bias example for you, although, it’s falling apart as we speak. There’s been a huge obsession right now with gold. This is one of our favorite topics, I think, because we’ve talked about it before, but recently gold has been on fire. Gold price has gone from about $1,530 an ounce, at the beginning of the year, to almost $2,100 a few days ago. And by the way, as we beginning to talk about the… You and I were talking about this yesterday, we were going to do this podcast this morning. Gold was dropping hard, it’s already down to $1,940. So, it’s already… It dropped six or something percent yesterday alone. But even if gold was at $2,100 an ounce, it’s nowhere near the $5,000 price that one of the most prominent gold bugs has been promising for over a decade. Yet people are buying like made. What’s going on here? Why would somebody invest in gold? And if you’re going to let recency bias drive your investment process, how much would you put into it?

Jeff DeMaso:
Yeah. Well, let’s start out maybe by laying out the “case for gold” today, and I know you’ve got some thoughts as well on gold so please jump in here. Today someone might be willing to buy gold in part due to that low yield world that I talked about earlier on here. A knock on gold is that it doesn’t pay a dividend, you just own a shiny rock (or not-so-shiny rock). So no dividend. And that is usually a negative, but in today’s low yield with money markets yielding the near zero bound of around a basis point, 10-year Treasury yielding 0.6%, that’s less competition for gold so suddenly gold doesn’t look so bad given that it’s not paying out a dividend.

Dan Wiener:
So it’s the lesser of evils? I mean, just because you’re not getting a very big yield on your other investments, you’re going to buy gold where you’re guaranteed not to get any yield at all?

Jeff DeMaso:
Sure. I mean, that’s an argument right now out there is that the opportunity costs of gold when it comes to income is less so that makes gold look less bad in some eyes. Where the other piece of it is concerns about inflation and the dollar. Rightly or wrongly, people feel that the Fed is putting a lot of money into the system, money supply is up over the past year, we were running a large deficit, we’ve disrupted a bunch of supply chains due to COVID and restrictions on travel. I think, in the past, in 2011, we saw a lot of those same concerns coming out of the great financial crisis and the quantitative easing then, a lot of concerns that that was going to lead to inflation and it didn’t play out. But nonetheless, those narratives are coming to the fore again today.

Dan Wiener:
I just don’t buy them. I don’t buy the inflation narrative and I never have. I mean, gold and inflation, you almost can’t have the two in separate sentences. But gold doesn’t protect you against inflation. Let’s assume there’s inflation, which you and I both don’t see any evidence of right now. If you look at gold and you go back through history, go to the ‘80s, early ‘80s when gold hit its all-time peak at the time, if you inflation adjust that price up to today, you’re not even close. I mean, it’s about 2,800, the last time I did the calculation, $2,850 an ounce. We’re not even close to that today. So where is the inflation protection that people keep talking about with gold? It hasn’t even kept up with inflation. You know what the best inflation fighter is? I mean, I’ll test you on it, but you know the answer, it’s stocks. Yep. I mean, where is the inflation? We have not seen it in the numbers. We got PPI and CPI numbers this week, absolutely no inflation in the system. Yeah, it’s going to come at some point, maybe, but we’ve been saying that since the financial crisis, as you said, and it hasn’t appeared.

Jeff DeMaso:
I mean, Dan, you make a good point. Look, I’m trying to give the argument for gold without it being necessarily where I would put my dollars at. But, it’s the narrative about gold. Gold isn’t a productive asset, it isn’t a company that’s growing earnings or improving people’s lives. So it’s really about the story that investors are telling themselves about gold. And if there’s concerns about the world, whether that’s a pandemic, tensions between US China, you can tell yourself a story about money supply and inflation. That’s the narrative that people are telling around gold today.

Dan Wiener:
Yeah. But the other issue of course, is that most of the people who are investing in gold today aren’t buying physical gold, they’re not holding it. And if they were, of course, they’d have to have it in a vault somewhere, particularly if they’re going to buy enough to make a difference, they own gold ETFs like the SPDR GLD or the, iShares IAU. So, if you’re a doomsdayer and your notion is that the gold ETF is somehow going to protect you if the dollar goes to hell. Well, that’s ludicrous. I mean, your ETF, your brokerage accounts, they’re all denominated in dollars. How does a gold ETF protect you? It doesn’t. And if you’re going to buy the physical gold, good luck finding someone who’s going to trade you for it.

Jeff DeMaso:
Couldn’t agree more, if you own the gold ETF and it comes to the time where you think you actually want to need spend, get your hands on that physical gold because the world’s going to hell, good luck on getting that out of the vault in London where it’s stored and over to you here in the US. It’s just not going to happen.

Dan Wiener:
Right. Well, all right. You know my line about gold. The best investment you can make in gold is to put some around the neck or the finger of someone you love. And I’m going to leave it at that. The last recency bias, if you can call it that, issue I wanted to get into was, again, value investments are on the comeback trail. I saw my first couple of notes on that just today on the web. Value stocks of all sizes are outpacing growth stocks so far in the month of August. Talk about recency bias that comes around again and again and again, what do you think of that?

Jeff DeMaso:
Yeah, it’s the classic growth-versus-value conversation. Everyone seems really eager to be the one to call the turn and call that tech stocks are in a bubble and it’s time for value. It’s interesting because I actually take almost a different lesson from recency bias and it’s that value stocks keep just giving this head fake of taking the lead, but without actually being able to really hold it over growth stocks over any meaningful time right now.

Dan Wiener:
Yeah. I mean the long-term history, of course, depending on how you define long-term, in some cases shows that value outperforms growth, you can look at other periods when growth outperforms value. But the bottom line, again, going back to something we talked about earlier, is diversification. You got to have diversification, and don’t go by the labels, we don’t diversify by something that’s called value or something that’s called growth, we really look under the hood of the funds, in the portfolios, the managers we work with to see what it is they’re buying and whether they’re buying growth stocks at value prices or value stocks that are on a growth spurt. I think that’s really the answer when you are starting to feel this recency bias begin to grab your investment head. And let me just ask you, can you think of a time recently when you were actually thought you might begin to be biased by recent events, and then you said, “Wait a minute, I’m falling prey to recency bias myself.”

Jeff DeMaso:
Absolutely. Yeah, I think a recent example is around COVID-19 and cases and its impact on the market. In March, we saw stocks fall as cases were rising and spiking, and we were shutting down and closing our economies as we sheltered at home to try and contain the virus. Well, the past few months in the U.S., June, July were good months in the market, but that was also seen with rising cases across many parts of the US. And that just didn’t seem to match up, and it was because I was falling back on the recent lesson in March that rising COVID-19 cases leads to falling stock prices. But that’s only one data point, but it’s the most recent data point that I had. So then seeing experience in June and July, it just wasn’t adding up. But in part that’s because I was just being informed by one recent event; I recognize that this as a much more complicated situation.

Dan Wiener:
Right. Yep. Well, again, it’s all about diversification. I think that the lesson on recency biases is to be aware, when you’re reading a headline or reading a story in the news, thinking about the most recent occurrences, either in the market or in the news cycle, how it is changing your investment view and whether it’s makes sense to do that and whether you are falling prey to recency bias. Just be very smart about how you manage your portfolio, if you’ve done a good job diversifying, you know what your objectives are, you probably need to just ignore what’s going on today and tomorrow.

Jeff DeMaso:
Yeah. This is where having a plan, a financial plan and an investment plan in place ahead of time is really helpful so you can fall back to that.

Dan Wiener:
All right. Let’s let people give back to their portfolios and not thinking about what happened today. This has been Dan Wiener.

Jeff DeMaso:
And Jeff DeMaso.

Dan Wiener:
From Adviser Investments, thanking you for listening to The Adviser You Can Talk To Podcast. If you enjoyed this conversation, please subscribe and review our show. You can check us out at adviserinvestments.com/podcasts. Your feedback really is always welcome and if you have any questions or topics you’d like us to explore, please email us at info@adviserinvestments.com. And as always, I’d like to thank Kailey Steele, our editor and super-producer, for making this podcast a reality. We couldn’t do it without her. And thank you for listening.