The third quarter of 2022 brought more economic, political, and geopolitical volatility for investors. Notable market events for the quarter were as follows:
Third quarter returns for equity and fixed income asset classes were lower across the board:
Third Quarter 2022
|Bloomberg U.S. Govt./Credit—Int.||Fixed Income||-3.1%||-9.6%|
|S&P 500||Large U.S. Stock||-4.9%||-23.9%|
|Russell 2500||Small/Mid U.S. Stock||-2.8%||-24.0%|
|MSCI ACWI ex-USA IMI||Foreign Stock||-9.9%||-26.5%|
|S&P Global REIT||Real Estate Securities||-11.1%||-29.2%|
It can be tempting to dwell on the gloomy financial headlines, and the natural investor temptation during tough economic times is to get out of the stock market – or at least reduce stock exposure – until “the dust settles” or “the outlook improves.” Unfortunately, there is no historical or academic evidence that investors can reliably and consistently time markets in this manner. The evolving academic field of behavioral finance has much to say about how investors can learn to cope in volatile market environments, like we are experiencing now. In short, behavioral finance advocates that humans are not wired like the rational subjects found in economic theories; rather, we have a multitude of behavioral tendencies that serve us well in most areas of life, but which are suboptimal for economic decision-making. We would like to examine three behavioral tendencies that frequently impair even the best-laid plans of investors: overconfidence, confirmation bias, and herd behavior. Falling prey to these behavioral traps often leads to investment decisions based on emotion, rather than sound long-term planning and disciplined execution.
We will start with overconfidence. Whether considering our athletic skills, our sense of direction, or our investing ability, few of us are immune from overestimating our knowledge and abilities. The example most relevant to investing is the belief that with little knowledge, experience, or due diligence, individuals can pick stocks that consistently beat market indices. Academic research has proven time and again that this simply is not the case, even with substantial experience and research. Many investors have encountered people who were “smart” enough to exit the stock market in the late 1990s, thereby missing the sharp decline of the tech crash of 2000 through 2002. It is unlikely, however, that these same investors were later smart enough to get back into the market for the entire 2003 through 2006 period, during which the S&P 500 Index returned an average of 15% per year, pull out prior to the 2007-2009 financial crisis, jump back in on March 9, 2009, to enjoy the subsequent 11-year bull market, and then perfectly time the COVID downturn of 2020. Being out of the market during the “good” periods of time that followed these bear markets likely negated much, if not all, of their prior market timing gains.
Beyond overconfidence, investors must fight a subconscious inclination to seek information and feedback that reinforces their pre-existing beliefs. Confirmation bias makes it challenging to break patterns of thought and behavior because it specifically leads one to seek and find support for even the most questionable investment ideas and to reject evidence that does not support his or her original ideas. Confirmation bias may be most evident in those who consume only media sources that support their world view. An investor who is committed to owning shares of a particular company, for example, may subconsciously ignore all unfavorable news about that company and only process positive news. These tendencies can be alleviated by exposing oneself to a wide variety of thought and opinion and seeking constructive critiques to one’s own decision-making process. The savviest decision makers seek information that may be contrary to their opinions to see if their ideas stand up to direct challenge. It may be surprising to some, but many financial advisors choose to have another advisor manage their investment portfolios for this very reason. Highly elevated emotions can lead even the most seasoned investors to make suboptimal decisions in the short-term.
Herd behavior is our natural tendency to base our decisions on the actions of others. When the market sells off as it has lately, our fight-or-flight instinct may tell us the safest thing is to follow the herd and sell our investments (just wait until everything settles down!). By eliminating the possibility of further losses, selling alleviates our short-term pain and fear. However, this fear is quickly replaced by the angst of when to get back into the market. The real challenge in taking counsel from those who do not know your financial goals is to not abandon your own instincts, common sense, and reasoning. In the short run, herd behavior can create dramatic shifts, commonly leading to costly overreactions and missed opportunities. While collective knowledge may be good, too much noisy information can be both counterproductive and destructive.
Lastly, and not particularly a component of behavioral finance, the notion that “forecasting” future events can help with investment decisions is a common fallacy. Making accurate forecasts about the future, when an unlimited number of variables exist, is extremely difficult to do. A quote from the late economist John Kenneth Galbraith sums up the inability to make accurate forecasts brilliantly: “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.”
Studies have shown that investors who tune out most financial news fare better than those who subject themselves to an endless stream of mostly meaningless short-term information. Rather than investing with emotion, our focus for each client remains maintaining an appropriate asset allocation, diversifying broadly, keeping costs and taxes low, and rebalancing in a disciplined manner as market conditions change.
The U.S. stock market has considerably outperformed foreign stocks over the last two decades. More specifically, the S&P 500 index of large U.S. companies outperformed the MSCI ex-USA IMI index of foreign companies by approximately 3% annually over the last 20 years. So why would investors allocate a portion of their portfolios to underperforming foreign stock markets going forward? We thought it would be helpful to discuss why our client portfolios include an allocation to both domestic and international investments.
For decades, the primary rationale for investing in foreign stocks has been to improve overall portfolio diversification, which both reduces risk and improves long-term returns. Due to variances in economic growth and other factors among countries, foreign stocks tend to be less than perfectly correlated with U.S. stocks, thereby improving the risk/return profile of the overall, diversified portfolio. Even with the growing interconnectedness of the worldwide economy, we continue to believe that foreign stocks deserve a home in a broadly diversified portfolio. With approximately 40% of the world’s equity investment value found in over 18,500 non-U.S. companies, U.S. investors miss out on a tremendous amount of global investing opportunities if they shun foreign-based companies.
The U.S. equity market has had strong performance relative to other developed countries for much of the last two decades but has been the top performer amongst developed countries just once (2014) in the last 20 years. Will the strong relative U.S. performance streak continue over the long-term? It is impossible to say, but the recent trend of a U.S.-only portfolio outperforming a globally diversified portfolio is unlikely to continue indefinitely. Since predicting which global market will perform best in any given year is impossible, we believe patience and diversification are essential.
Although we consider international stock investment to be fundamental to long-term investing, Dowling & Yahnke does have a “home bias” in our portfolios because we live and spend in the U.S., meaning we hold a larger allocation to the domestic market than a market-weighted global portfolio would dictate. While foreign investing can greatly improve diversification, it does not eliminate all risk. Global diversification helps protect portfolios against risks specific to a particular company, industry, or country, but does not protect against systematic risks, such as war, pandemics, political turmoil, or other events that impact global financial markets in general. The value of diversification should not be judged over short periods of time, and foreign investing can certainly leave investors feeling frustrated at certain points in market cycles. However, international diversification remains an essential tool for improving returns and reducing risk in investment portfolios.
As we enter the final months of the year, we would like to remind you of a few timely administrative items related to taxes. If we have not already, we may be consulting with those of you who are obligated to take required minimum distributions (RMD) from IRAs and other retirement accounts by December 31. Please inform us of any IRAs you own that are not managed by our firm so we can take them into account when calculating your RMD. If you plan to make charitable donations of appreciated stocks or other securities in 2022, please notify us as soon as possible. We ask that all service requests be sent to our team by Monday, December 5th, so we have adequate time to process them prior to the very busy year-end. Finally, if we are not currently reporting tax information directly to your tax preparer and you would like us to do so, please provide us with his or her name and contact information (including email address) by the end of the year.
We continue to be excited about our partnership with CI and our CI Private Wealth partner firms. As many of you have already experienced, we now have a broader and deeper network of expertise to draw upon, particularly with specialized topics. We also look forward to sharing more about some new service offerings that we’re able to provide to our clients as a result of our larger scale. Because we are collaborating closely with our likeminded colleagues, we are rolling out a new logo designed to reflect that partnership. We are working toward being co-branded as CI Dowling & Yahnke Private Wealth. Along with the new logo will come a new look across all our communications. But while our logo will look different, we are still the same team with the same steadfast 30+ year commitment to our San Diego community and to providing personalized, world-class financial advice to you.
We appreciate the trust you have placed in us to guide you through these ever-changing times. We encourage you to call or e-mail anytime you would like to discuss your portfolio or your financial plan.
DOWLING & YAHNKE WEALTH ADVISORS