Insights from Omar Aguilar
CIO, Equities and Multi-Asset Strategies
Cognitive biases are tendencies that prompt us to think in certain ways, sometimes in directions that can lead us astray. Although we may prefer to believe that we consider and evaluate data and facts before ever reaching a conclusion, many of us frequently employ a far less calculated approach and instead revert to mental shortcuts. These shortcuts, or mental heuristics, may include an inclination to associate recent events as supporting previously established notions.
From a behavioral finance perspective, the propensity for humans to extrapolate their most recent successes as justification for continuing along the same path is called “hot-hand fallacy.” “Cognitive dissonance” and “confirmation bias” often pair with hot-hand fallacy, and can cause investors to ignore information that might refute their desire to maintain a previously successful strategy and cause them to instead selectively focus on incoming data that seems to support the status quo. From a generational standpoint, these behavioral finance precepts appear to affect baby boomers more than Generation X or millennials. I discuss the effects of hot-hand fallacy, cognitive dissonance, and confirmation bias in this issue of my quarterly investment insights.
Since the end of the 2007-2008 financial crisis, lackluster economic growth and deflationary pressures have forced many central banks to confront the limitations of conventional monetary policy. In response, some central banks have turned to unconventional tools like quantitative easing (QE), where a central bank purchases sovereign bonds in an effort to drive down interest rates and drive up consumer spending and capital investment. At present, the European Central Bank, the Bank of Japan, and the Bank of England are employing this approach. For example, the Bank of Japan is currently targeting the purchase of more than $700 billion of Japanese government bonds per year, or approximately 15% of the country’s gross domestic product (GDP). The following chart illustrates the size of these collective QE efforts, which have been increasing in recent years, even as the U.S. Federal Reserve (the Fed) has unwound its own QE programs.
Negative interest rate policies are another unconventional tool currently being employed by many central banks. As a percentage of GDP, more than half of the outstanding sovereign bonds in the developed world originated from countries or regions where negative interest rate policies are in place, primarily representing bonds from the euro zone and Japan.
Incorporating potentially higher-yielding asset classes into a portfolio without carefully considering the additional risks that these securities may pose could prove to be a costly mistake.
With Group of Seven (G7) sovereign bond yields at historically low levels, some income-seeking investors have turned to higher-volatility securities like dividend-paying stocks in an attempt to capture additional income. The lack of global economic growth, an accommodative Fed, and “Brexit” have further accelerated investor demand for these strategies. However, incorporating potentially higher-yielding asset classes into a portfolio without carefully considering the additional risks that these securities may pose could prove to be a costly mistake.
During the first half of 2016, a rotational migration to low volatility, potentially higher-income assets became evident, as did the outperformance of dividend-generating stocks. The Consumer Staples, Utilities, and Telecommunications sectors have historically paid out higher dividends than other sectors. As shown in the chart below, these sectors largely outperformed other sectors in the S&P 500 Index during the first nine months of this year, pointing to the potential for price-earnings ratios on many of the underlying securities to be trading at distorted levels that seem likely to prove unsustainable over the long term.
Many baby boomers seem to show a tendency for following investment trends, making this generation potentially susceptible to the effects of hot-hand fallacy, cognitive dissonance, and confirmation bias.
Many baby boomers seem to show a tendency for following investment trends, making this generation potentially susceptible to the effects of hot-hand fallacy, cognitive dissonance, and confirmation bias. The technology bubble of the late 1990s and more recent real-estate bubble represented clear examples of such behavior. During each market dislocation, some boomers maintained their investment strategies beyond fair-valuation levels, ignored the growing evidence of market dislocations, and instead selectively focused on information that confirmed their desire to maintain their hot-hand strategies.
Millennials tend to behave differently than baby boomers, while Generation X is somewhat of a hybrid between these two generational extremes. Millennials often prefer to seek recommendations, while questioning the prevailing wisdom and adopting contrarian viewpoints. As a result, millennials tend to avoid jumping into popular investment trends with both feet and may have less to worry about in the present environment. This generation grew up during an era of “unprecedented” market events, leaving a pronounced impression on their investment rationalizations and providing important context for their behaviors. Like baby boomers, Generation X is somewhat at risk from the hot-hand fallacy, cognitive dissonance, and confirmation bias. Generation X shares some of the characteristics of both baby boomers and millennials, although tendencies for Generation X appear to vary more widely from individual to individual.
The chart below illustrates why we believe that valuations on dividend-paying stocks may be overinflated. The chart shows the cumulative returns of the S&P 500 Index and the S&P 500 Dividend Aristocrats Index, which measures the performance of S&P 500 companies that have raised dividends every year for the last 25 consecutive years. As the chart reveals, the S&P 500 Dividend Aristocrats Index returned 13.6% more than the S&P 500 Index from the start of 2014 through the end of September 2016. In an environment where global sovereign bond yields remain lower for longer, the relative performance disparity between these gauges could widen even further, begging the question of what might happen when sentiment eventually shifts.
In light of this valuation backdrop, we believe that it is important to remember the propensity for equities to recover their valuations over time. The growing possibility of mean reversion in the U.S. Consumer Staples, Telecommunications, and Utilities sectors is something that we believe baby boomers in particular may want to keep in mind. According to the Pew Research Center, approximately 10,000 baby boomers are retiring every day, driving up the demand for income-producing investments.
As a result, boomers may currently be more predisposed to increasing their allocations in higher-yielding stocks than other generations.
We believe that it is important to be wary of the effects of the hot-hand fallacy, cognitive dissonance, and confirmation bias, particularly in the current environment. These behavioral finance influences can skew a portfolio’s overall allocations toward an overemphasis of potentially higher- yielding equities that in some instances may represent more downside risk than upside potential at current valuation levels. Baby boomers seem more likely to have fallen prey to these behavioral factors than other generations, driven in part by their desire for an enhanced retirement income stream in the historically low yield environment. However, this approach could potentially compromise the long-term performance of their portfolios.
We also believe that the historically low interest rate environment may not last much longer. Such an outcome could put select higher-yielding stocks at risk if sentiment continues to shift away from value-oriented investments and toward more growth-oriented strategies, as we witnessed in September. The U.S. housing market remains in full recovery mode, U.S. stock indexes are at or near new record highs, and overall employment conditions continue to improve, with the unemployment rate hovering around 5.0% and wage-inflation pressures emerging. Signs of improvement in the U.K., Europe, or Japan would likely support any evidence that U.S. economic growth is gaining momentum. Such a dynamic could lead to a rotational sentiment shift toward cyclical growth sectors and away from value-oriented equities, which up until recently had driven the majority of the market’s performance this year. As history has shown repeatedly, equities tend to recover their valuations over time, so allocating a portfolio accordingly may make sense to help prevent being burned by a hot hand.
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Omar Aguilar is Chief Investment Officer (Equities and Multi-Asset Strategies) of Charles Schwab Investment Management Inc. (CSIM), subsidiary of The Charles Schwab Corporation. Aguilar joined CSIM in 2011 and is responsible for equity and asset allocation mutual funds, ETFs, and separately managed accounts. Aguilar has more than 20 years of broad investment management experience in the equity markets, including managing index, quantitative equity, asset allocation, and multi-manager strategies. Aguilar received a BS in actuarial sciences and a graduate degree in applied statistics from the Mexico Autonomous Institute of Technology (ITAM). He was a Fulbright scholar at Duke University’s Institute of Statistics and Decisions Sciences, where he earned his MS and PhD.
Past performance is no guarantee of future results.
The opinions expressed are not intended to serve as investment advice, a recommendation, offer, or solicitation to buy or sell any securities, or recommendation regarding specific investment strategies. Information and data provided have been obtained from sources deemed reliable, but are not guaranteed. Charles Schwab Investment Management makes no representation about the accuracy of the information contained herein, or its appropriateness for any given situation. Some of the statements in this document may be forward looking and contain certain risks and uncertainties.
The views expressed are those of Omar Aguilar and are subject to change without notice based on economic, market, and other conditions.
Indices are unmanaged, do not incur fees, and it is not possible to invest directly in an index.
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