Oops! Here We Go Again

When will investors (and many financial advisors) learn the potential perils of chasing returns?
 
Take a look at the chart below showing flows into bond funds from 2009 through 2012. Billions of dollars poured in, year after year.
 
Equity and Bond Flows 2004 – 2013
 

 
Meanwhile, despite five-in-a-row positive years for U.S. equity markets, investors fled stocks until the bond market turned sour in 2013, with a 15.1% decline in 30-Year U.S. Treasuries.

Staying Invested – Even at New Market Highs

It can be very hard to start investing or stay invested when financial markets reach new highs. Our intuition tells us that after a long period of sustained performance maybe “we’re due for a correction.” This intuition is seen in many areas besides financial markets, such as in baseball, when a batter is “due” for a hit after not getting a hit over the past few games. This intuition also appears when gambling, with the belief that you might be “due” to see the ball land on black after a string of red spins at the roulette wheel.

Mental Landmines II – Hot Hand Fallacy

In our last post, we talked about the gambler’s fallacy and how it can fool investors into thinking that since there has been a run of good stock market performance, we must be due for a downturn. Now let’s look at the hot hand fallacy.
 

In sports, the hot-hand fallacy leads one to predict that a player will continue to be hot because his recent performance has been hot; for investors, it is the fallacy that a hot manager or asset class will continue to perform well given recent performance.

Mental Landmines—The Gambler’s Fallacy

Imagine showing your clients the annual returns for the S&P 500 index for the past five years, as displayed in the table below.
 
If you ask each client what they think will be the odds of the S&P 500 earning a positive return in 2014, how do you think they’ll respond?

S&P 500 Annual Returns
Year	2009	2010	2011	2012	2013
Return	26.5%	15.1%	2.1%	16.0%	32.4%

Source: Morningstar Direct, January 2014 Past performance does not guarantee future results. Indexes are unmanaged baskets of securities in which investors cannot directly invest; they do not reflect the payment of advisory fees or other expenses associated with specific investments or the management of an actual portfolio.