After a 26% gain in 2023, U.S. stocks followed up with a near-repeat performance in 2024, driven once again by strong returns from large technology companies. Other asset classes contributed positively to your portfolio performance. Insurance-linked securities were the top-performing asset class for the year, while real estate securities lagged the others for the second straight year.
The Recency Bias
We often discuss concepts from the field of behavioral finance. Much of the academic literature on behavioral finance characterizes financial decision-makers as irrational. I prefer the interpretation that the field is instead about “finance for normal people.”
One well-known “normal person” tendency is to give greater importance to recent information and experiences while placing less emphasis on occurrences from the past. Consequently, our perception of recent events can have a disproportionate impact on how we think about the future. In investing, that means good times tend to create optimism for the future, while bad times can lead to a pessimistic outlook.
If the study on the left is any indication, the good times from the past two years of positive stock market returns have created an unusually high amount of optimism. The chart shows the outcome of a survey conducted by The Conference Board, which produces research on topics such as consumer confidence. In this survey dating back to 1990, never have so many respondents expected stock prices to rise over the coming year.
Notice respondents were not nearly so optimistic following 2022. Stocks declined nearly 20% that year. The beloved U.S. technology giants all lost more than 25% in 2022, with the majority declining nearly 50% or more. Having seen how the last two years of stock market returns panned out, the end of 2022 was not a good time to turn pessimistic.
As we know, investors would be better off ramping up their optimism when stock prices are down and prospects for future returns are brighter. But “buy low and sell high” has always been easier said than done. Human nature is what makes it so.
Investing Beyond Today’s Market Trends
On the topic of “recency,” I am interested in a related point. When recent trends have persisted for years, it can become even harder to avoid extrapolating the present into the future. Given enough time, it can seem as though recent performance trends are destined to persist because it is difficult to remember different past market environments. Let’s look at two examples I believe are relevant to today.
Over the past decade, bonds have produced very low positive returns against the backdrop of a roaring U.S. stock market. One can see how investors conditioned in the recent past would not view bonds favorably. The performance advantage for stocks versus bonds in the past 10 years has been greater than nearly every other 10-year period since the early 1960s.
Another example involves the performance of U.S. stocks versus other developed market countries. U.S. stock returns have ranked either #1 or #2 out of 18 developed market countries in every 10-year period since the decade ending 2016. Put more simply, U.S. stocks began to outperform world markets around the time of the financial crisis (2008) and have been at it ever since. This period has been long enough for many to call into question the value of global stock diversification.
So, how can we guard against the natural tendency to extrapolate recent trends as we think about the future? With each of these examples, it is useful to consider what has changed in the investment landscape. For bonds, the change is quite clear. Increases in interest rates have led to improved prospective returns — higher now than at any point in the past 15 years.
For U.S. stocks, the incredible success of the recent past has resulted in high prices in relation to corporate earnings (i.e., valuations). U.S. stocks are now within 15% of the all-time peak in valuations from the late 1990s “dotcom” era. Typically, periods of higher stock valuations have resulted in lower subsequent returns. The historical data on country stock returns also shows the top-performing country in any one decade most frequently underperforms in the decade that follows. It should, therefore, not come as a surprise if U.S. stocks take a breather while other markets or asset classes step into the leading role, whenever that may come.
Both a broader view of history and an evaluation of current market conditions should provide some caution to those who expect recent market trends to persist indefinitely. The all-weather investment strategy underpinning your portfolio is ready for whatever comes next.
As always, we look forward to our next conversation.
