Don’t Invest in the Rear-View Mirror

November 5, 2012

Investors face many behavioral biases—that’s just part of being human. Perhaps the most difficult to overcome is recency bias: the tendency to believe what has happened in the immediate past is likely to continue in the future.

Although experienced investors understand short-term market movements are random, once patterns develop over three to five years the gurus start calling them new paradigms. Then they urge us to change that stodgy old strategy that isn’t appropriate anymore and encourage us to adapt to the new normal.

Problem is, while this sounds wise, it’s little more than performance chasing. What happened over the last five years cannot help you during the next five years—in fact, investing in the rear-view mirror is almost certain to produce disappointing results. To see why, let’s turn back the clock five years to the autumn of 2007, when investors were enjoying a full-on bull market following the tech wreck of the early 2000s. Imagine sitting down for a meeting with your advisor who shows you the following performance numbers:

Annualized returns: Five years ending October 2007
S&P/TSX Composite 20.99%
Russell 3000 (in USD) 14.83%
Russell 3000 (in CAD) 3.91%
MSCI EAFE (in CAD) 11.95%
MSCI Emerging Markets (in CAD) 26.97%
US dollar versus Canadian dollar -9.51%

Source: Dimensional Returns 2.0

These results are pretty dramatic: Canada absolutely pummeled the US even when performance is measured in local currency. And when you consider US stock returns in Canadian dollars, they look far worse: the greenback lost about 9.5% of its value annually during this period. Meanwhile, international stocks in both developed and emerging countries delivered outstanding returns to pick up some of the slack.

If you were inclined to reposition your portfolio based on these results, what would your asset allocation have looked like after that 2007 meeting? You likely would have loaded up on Canadian stocks and emerging markets. Of course, you wouldn’t have called it performance chasing—that’s something other people do. You would have rationalized it by saying that Canada’s resource-rich economy was well positioned in the global economy, and that emerging markets like China and India were poised for strong GDP growth. If you were inclined to invest in the US all, you likely would have elected to use currency hedging, because it was “obvious” the US dollar would continue its downward trend.

My, how you’ve changed

Well, we all know a lot happened over the subsequent five years. Let’s have a look at what the markets have delivered since November 2007:

Annualized returns: Five years ending October 2012
S&P/TSX Composite 0.22%
Russell 3000 (in USD) 0.58%
Russell 3000 (in CAD) 1.72%
MSCI EAFE (in CAD) -4.28%
MSCI Emerging Markets (in CAD) -2.08%
US dollar versus Canadian dollar 1.13%

Source: Dimensional Returns 2.0

As you can see, these numbers bear no resemblance to those of the previous five years. Not only have US stocks significantly outpaced Canada and the rest of the world (albeit with low returns by historical standards), but the US dollar appreciated more than 1% annually, which boosted returns for Canadian investors who did not use currency hedging. Emerging markets, the stellar performers of the mid-2000s, have delivered negative returns since then.

I’m constantly asked whether I think it makes sense to adjust my model portfolios to focus on dividend stocks, to allocate less to Europe, or to add exposure to gold. I hope my answer will be obvious: all three of these strategies would have performed extremely well over the last five years, and if I had a time machine, I would go back and change the model portfolios. But these recent trends tell us absolutely nothing about how to position our portfolios for the next five years.

The most sensible strategy, then, is to build a broadly diversified portfolio with a risk level that matches your investment goal and your temperament, and to rebalance regularly without making forecasts. It sounds so easy, but recency bias can make it awfully difficult to stick to that plan.

{ 29 comments… read them below or add one }

Onkar November 5, 2012 at 6:08 pm

Excellent topic. I myself have been guilty of that not only which index has done well but which mutual fund have done well in that past and got into it. Just recently fell into the trap again with dividend stocks/etf. However I looked at two my portfolio which were setup as couch potatoes(since 2007) they had done much better than any of the other ones. In the past 6-7 months, I have go through creating a plan, asset allocation that I would be comfortable with, now implementing that plan. I have been consolidating all of the assets into one brokerage. Part of the plan is saving aggressively, this part we have down packed, we save 65-70% of our net. Now focus is on implementing and maintaining the asset allocation. The part I am playing close attention to is cost(that was not top of mind before) but after reading a lot of material here on your blog and using the spreadsheet you provided, it has opened up my eyes with real $$$ so much was going to MERs. The problem with mutual funds(and etfs) is that fees are automatically taken out of NAV and you have no idea. I had mutual funds that were charging MER of 1.5% or more, where equivalent etf’s MER is .3%, if you buy US etf, its less than 10 bps. I think the implicit deduction of fees should be made illegal. The fees should be explicitly taken out of your account and/or reported as a separate line item on your statements, at least you will know in absolute $ what was charged.
Now my portfolio is broadly diversified with cash, bonds, equity(cdn, US, rest of world including emerging mkts), REITs etfs with MER of 0.26%. I am not betting the farm on a particular stock, sector or a country as I used to think I have the ability to figure out after watching BNN.

The SPY Surfer November 5, 2012 at 9:13 pm

I personally invest in the rear-view mirror, with a 6-month view to be precise. Combined with a tactical asset allocation (i.e. low-correlated asset classes), it works pretty well.

Lake Superior John November 5, 2012 at 11:02 pm

Again and again Dan you point out info that cannot be adulterated. Just plain old facts that your friendly broker probably wish you would not know about. Danny boy keep this non argumentable info available for us. Its valuable and empowering!

Keep up the great work. Oh by the way , picked up your latest edition of the common sense portfolio ( actually purchased 2 books at Chapters) , nice work, easy reading, a great reference, and a superb book to give as a gift. Thank you

Noel November 6, 2012 at 2:53 am

I think rear-view mirror thinking in investing is related to the phenomenon of ‘social proof’ which is the force that pushes us to make the same decisions as others have because they have had outcomes which we are comfortable with, this case being influenced to invest in a way that has worked in the past. No matter how hard we try not to be, in the end we are pack animals who group together as a society and are conditioned by the people around us and the behaviours that appear to work around us even if logic guides us to a different conclusion.

This is also the incredibly strong force that is the reason that only a small miniority of investors fully index. Mostly everyone else is not doing it.

gsp November 6, 2012 at 8:06 am

Dan, your first table should end with:
US dollar versus Canadian dollar -9.51%

Frank November 6, 2012 at 8:54 am

Sometime I wonder if it not the same bias when financial expert to encourage to buy bond in today market. They said you would done well if you got a lot of them all the last crisis but now the the return are on bond are low and more the time go and bond with big coupon bond are getting rare. With some institution that are giving 3% in TFSA saving account I don’t even see the advantage to risk money in bond fund until the coupon are getting higher.

Canadian Couch Potato November 6, 2012 at 9:46 am

@Superior John: Thanks for the support!

@SpySurfer: What you describe is quite different: it’s momentum investing based on specific criteria, rather than mindless performance chasing. While I don’t doubt there is a “momentum premium” it is notoriously difficult to capture over any meaningful period.

@Noel: Social pressure surely enters into it, especially of you are part of a peer group that enjoys investing. Saying that you remain broadly diversified at all times because you have no idea what will happen in the future—that’s a conversation stopper.

@gsp: Thanks for spotting the error, which is now fixed.

@Frank: I would agree that some investors seem oblivious to the risk inherent in bonds. They have done so well for so long, but the mathematics suggest that cannot continue. If you’re able to get 3% in a savings account, that certainly beats a government bond at 1.5%. Just be aware that financial institutions offering these rates may pose restrictions on when you can access your money, and they can lower the rate whenever they want to.

Neil Jain November 6, 2012 at 10:11 am

Excellent article, Dan!

Noel November 6, 2012 at 11:19 am

@Canadian Couch Potato: Given your response to @Frank, should someone who is 45 years old and is moving of all their investments from active management (with poor long term results) to a 100% complete couch potato portfolio and who has decided a 45% bonds/55% equities mix is appropriate for them be putting that much into bonds right now? Ok here I am now second guessing the strategy but your comment about the bond risk through me off a bit. Or is the risk more short terms (ie 5-7 years or so), not long-term (15 yrs+ which is the investors time horizon)?

The SPY Surfer November 6, 2012 at 12:05 pm

Thanks Dan for your comments. You’re right, the method I’m referring to is called relative strength which is based on momentum. It’s a known market anomaly that has generated excess return for the past 50 years in virtually all asset classes. It takes 10 minutes a month to implement with 5 broad-based ETFs, returning a +14% CAGR since mid 2006 vs. +1.5% for S&P500, with a much lower volatility.

Joe K November 6, 2012 at 12:45 pm

@The SPY Surfer:
Can you recommend a book on that type of investing stratedy?

The SPY Surfer November 6, 2012 at 1:21 pm

@Joe K – Sure, just go there: or email me at (full disclosure: I’m just a simple average DYI investor…)

Dale November 6, 2012 at 1:39 pm

The shortsighted rear view mirror is not very useful. But looking back and observing what strategies have worked over decades is all we have. All of the truth is in the past.

Warren Buffet keeps doing the same thing, over and over and over again. The future for investors like Warren Buffet, likely looks very similar to that image in the rearview mirror.

Dale November 6, 2012 at 1:41 pm

And here’s my latest. All in the rearview mirror. But the past has a habit of repeating itself over the longer term. Let’s hope so…

Noel November 10, 2012 at 7:59 pm

@Canadian Couch Potato – maybe you missed my comment on bonds but was wondering if you could comment. Thanks.

Canadian Couch Potato November 10, 2012 at 9:03 pm

@Noel: I would make two observations here. The first is that bonds in Canada have returned almost 10% annualized since 1980 and there have been virtually no periods where bond investors suffered negative returns for more than a year or so, because interest rates have trended steadily downward. No one knows where rates will move in the future, or by how much, but they cannot fall so far that those kinds of returns are mathematically impossible for the foreseeable future. The steady inflow of money into bond funds suggests many people are expecting too much.

That doesn’t necessarily mean you should change your asset allocation, because that is primarily a question of how much risk you are prepared to take.

In terms of Frank’s question, all I meant was that a broad-market fund like XBB currently has a yield to maturity of about 2.23%, while short-term bonds are yielding about 1.5%. So if he can invest in cash for more than that, with no risk of capital loss, it would be hard to argue with keeping his fixed income allocation in cash.

Noel November 11, 2012 at 1:25 pm

Your prompt and detailed answer is much appreciated. I ask because I am currently structuring a 100% indexed portfolio (the ‘Complete Couch Potato’) for a 45yo friend (house mortgage paid off, no debt, significant savings each month) who has been fleeced by brokers selling him high MER funds for many years (no portion of his mid- 6 digit portfolio has ever beat the appropriate benchmark). He has a 25 year time horizon and is comfortable with a 45%/55% fixed income/equity asset allocation, rising/lowering by 5% in the income/equity percentages respectively every 5 years as he ages.

Interest rates will certainly start a steady rise at some point in the next few years, but who knows if that will start to happen in 2, 5 or 10 years from now. We are certainly at or near the bottom of the valley plain in terms of rates as they cannot get too much lower (hard for the Bank of Canada rate to go lower than zero!). Athough the yield to maturity of XBB at 2.23% is historically low and with rising rates the price of bonds in that ETF will fall, they are being held to maturity and will be replaced, when and if rates rise, by higher yielding bonds. Thus, the yield to maturity of XBB will at worst remain relatively stable or maybe move a bit lower but will eventually rise over time but who knows when or by how much.

XBB will be held in held entirely in his RRSP. I did a survey of RRSP daily savings rates vs GIC rates and they range from a 1.40% daily savings to a 5-year fixed rate of 3.15%, both with ICICI Bank. Certainly the 1.40% rate will rise as interest rates rise and so will the 5 year-fixed rate. How one chooses between XBB vs one, both or a blend of these two rates or maybe even including XBB in the mix seems to depend on a judgement call about where rates are going long-term and how soon any change will happen, but that flies in the face of index investing not requiring one to make such a decision. A blended rate of 50%/50% daily savings/5-yr GIC would at this point provide a rate of (1.40%+3.15%)/2 = 2.275% which is slightly higher than XBB’s yield to maturity.

So, my question is can you guide me at all (and I am sure many other readers are questioning what to do) in terms of how to make the decision between these two savings rates vs. XBB given how historically low rates are now?

Canadian Couch Potato November 11, 2012 at 4:06 pm

@Noel: I can’t tell you what decision is right for your friend, but I let me offer a couple of observations. First, think of the decision in terms of risk, not in terms of trying to predict interest rates. If your friend has a 15-year horizon, then he will not lose capital invested in XBB (with its duration of 10) over that length of time. But he mat have to endure some volatility of rates rise and bond process fall. Is he prepared to do that, or would be be more comfortable with a savings account or GICs, where he will never see any decline in price?

Second, don’t agonize over this decision. It’s a very small one and the differences in yield will not have any meaningful impact on your friend’s ability to meet his financial goals. So make the decision you feel you are most likely to stick to with confidence and don;t second-guess yourself once you’re invested.

Oldie November 13, 2012 at 3:50 pm

CCP: Your comments on bonds have triggered renewed thinking about asset allocation for me. I have been distracted by home renovations for a couple months, and have delayed until now (imminently) initiating a large transfer of funds to a non-RRSP non TFSA account to be invested in a CCP style modelled loosely after the “Yield-Hungry CP” with the modification that for tax savings reasons the Canadian Equity component was to be filled by HXT and the US Equity by HXS. The problem is to devise a tax efficient treatment for the Canadian bond component. You had previously highlighted CAB (in fact it still represents the Canadian Bond component of your “Yield-HungryCP”) but subsequently warned that returns have significantly lagged the index. If that is still the case, and there is no reason in sight to expect relief, what’s a guy to do? 1) Buy plain vanilla XBB, suck it in and pay the tax when interest or dividend is distributed, 2) Buy CAB and hope that promise turns to realization.

The strategy of restricting purchase of XBB only in my RRSP and not in the taxable account becomes unravelled if XBB value has risen significantly at rebalancing time, because there is no Bond component in the taxable account, and, being retired, it is not anticipated that new funds will be available for further investment to purchase HXT in the taxable account at the new low price; or the reverse problem HXT rises in value and XBB drops.

Canadian Couch Potato November 13, 2012 at 4:51 pm

@Oldie: The situation you describe is what plagues all conservative investors who have run out of tax-sheltered room. I wish there was an easy answer.

Conventional bond funds are extremely tax-inefficient, and while CAB offers a potential benefit, the size of that benefit really depends on how well it tracks its index (not very well), what portion of its distributions are characterized as return of capital (unknowable in advance), the fund’s yield (the higher, the better) and the marginal tax rate of the investor.

One option you didn’t mention is a GIC ladder. The interest is, of course, fully taxable, but GICs do offer some additional benefits because they don’t trigger capital losses. See this post by Justin Bender for more details.

Oldie November 13, 2012 at 5:47 pm

@CCP: Thanks for your prompt reply. Your link to Justin Bender’s post triggered a warning for a potentially dangerous web command on my MacBook computer; was this an Apple quirk, or is there something wrong with the site?

Also, I need clarification: I have always puzzled over how to handle the issue of balancing GIC’s in a CP portfolio. If the value cannot go up or down, how would we generate the signal to trigger buying or selling at rebalancing time? Is the underlying principle still the relative proportions of the asset classes? Or, to rephrase the question, is the signal to trigger buying or selling to rebalance asset class proportions generated solely by a change in value of your remaining component, that is, the Equity Index based ETF?

Canadian Couch Potato November 13, 2012 at 6:51 pm

@Oldie: Sorry about that—I fixed the link.

You’re right that GICs present a practical problem in that you cannot add or withdraw money from them, like you can with a bond fund. But it’s important not to think of rebalancing as an exercise in selling or buying according to “triggers.” The point of rebalancing is not to sell what is overvalued or buy what is undervalued. It’s primary purpose is risk management by helping you maintain a more or less consistent asset allocation:

Remember that with a five-year GIC ladder, one fifth of your money mature every year, so you do have an opportunity to move that money around in the portfolio if necessary.

Oldie November 13, 2012 at 7:55 pm

CCP: Thanks for the fix. And a very germaine and illuminating post by Justin Bender it is. I was all prepared to just go for XBB for the Income portion in my taxable account for simplicity’s sake and shrug off the tax implications. I was shocked at the potential tax shredding of the Bond fund yield.
“If you are unsure if the average underlying bonds of a pooled product are trading at a premium to par, just visit the company website and look to see if the Weighted Average Coupon (%) is larger than the Weighted Average Yield to Maturity (%) – if it is, you have yourself a basket of premium bonds.”

Well, checking XBB’s particulars; Weighted Average YTM = 2.23%; Weighted Average Coupon = 4.00% . Arrrgh! So much to learn. Paralysis by overanalysis is certainly a hazard to be avoided, but I’m overcome, temporarily, I hope, by the notion that I nearly made a huge blunder due to insufficient knowledge. Yield net of all costs, including taxes, is the bottom line. Much more studying is required!

Oldie November 13, 2012 at 8:34 pm

CCP: OK, accepting that CAB historically trails the Bond index by 1.0% (quoted from your Feb 12, 2012 post), that’s bad. But adapting Justin Bender’s example $105,000 investment in a 3 year GIC paying 1.5% per annum taxed at the full marginal rate of 39% (Alberta) gives you a net after tax annual yield of 0.915%, which is pretty mediocre even if it’s “safe”. I don’t know if laddering GIC’s materially changes the gist of my calculation. Suddenly, the “poorly performing” CAB doesn’t look that bad after all when the superior tax treatment is factored in. (I would think that the CAB Weighted Average YTM of 2.10% and Weighted Average Coupon of 3.75% is less significant here because of the Forward Arrangement treatment?) Sorry to hog the posts, but this is not a trivial comparison.

Canadian Couch Potato November 13, 2012 at 9:13 pm

@Oldie: If CAB pays all of its distributions as return of capital, it certainly could provide a better after-tax return. But you can’t compare a three-year GIC (or a five-year ladder) to a bond fund with a duration of six years: CAB has significantly more interest-rate risk. If rates rise, it will fall in value, while GICs will not lose principal. Remember, too, that CAB investors will have to pay capital gains taxes somewhere down the road, so it’s not like all of the return is tax-free.

I wish I could give you a straight answer, but I’m afraid there isn’t one. There simply isn’t any way to get safety of principal and inflation-beating returns in a taxable account. In the end it comes down to which risks you’re most comfortable taking.

Derek Kaye November 14, 2012 at 4:57 pm

An excellent post! Many so called ‘educated’ investors regularly fall trap to ‘recency bias’. Looking back, the only real thing you can count on is that the market is going to crash at least once every 8 years or so .. and it will always recover!



Que November 27, 2012 at 6:53 pm

You didn’t seem to say in your above comments that one is better than the other in terms of a GIC ladder vs a Bond ETF.
If rates rise, wouldn’t you be better off with a 7 year GIC ladder, or would your value be the same after 7 years once XBB has recovered with it’s higher yields?

Canadian Couch Potato November 27, 2012 at 7:24 pm

@Que: There’s no simple answer to that question. There is no such thing as a seven-year GIC ladder (CDIC insurance only covers five years), but if there were, it would have a duration lower than that of XBB, so it would be somewhat less risky in terms of maturity. XBB also has corporate bonds, which offer a higher yield but more risk than GICs. So one cannot say one is “better” than they other. They are just different in their risk-reward profile.

Que November 27, 2012 at 8:28 pm

I was just trying to find out which one would have the higher value after the comparable time.
Any chance of doing some sort of value comparison like you did here:
Thanks, Que

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