Rebalancing & Recency Bias - Simple Case Studies

If you are a fan of Dave Ramsey, you are likely aware with the concept of spreading out risk with long-term retirement investing by utilizing 4 categories of mutual funds and ETFs that include Growth, Growth & Income, Aggressive Growth, & International funds. One of our very own advisors, Logan Doup, explains the basics of these 4 categories in-depth in a previous article. You can read that article here to indulge yourself with building a simple foundation of knowledge for the concepts I eagerly dive into below. It is important to note that we are convicted in the potential value of this strategy involving spreading out roughly 25% of stock market investments (whether stock market investments comprise of all or only a part of your comprehensive investment portfolio) to these respective 4 categories through mutual funds and/or ETFs, regardless of fellowship or lack thereof with Dave Ramsey.

Whether this strategy makes sense for you could very well be a question worth investigation of goals, understanding, fit on a case-by-case basis, etc. However, what is less arguable, is that falling into the trap of recency bias has historically been harmful regardless of the specific underlying strategy. For the sake of these case studies, let’s stick with it. In all examples, let’s assume you are sitting with a portfolio that is 25% allocated to the entire Growth segment of the market, 25% to Growth & Income, 25% to Aggressive Growth, and 25% Internationally as of ‘YEAR 1.

Case Study 1

YEAR 1 – 1995

Investments made into account at 25% Growth, 25% Growth & Income, 25% Aggressive Growth & 25% International Allocation.

YEAR 12 – 2006

Out of the 4 categories, Growth was the best performing 4 years in a row from 1995-1998. It was the 2nd best performing category out of the 4 possible in 1999. Consequently, it was the 2nd worst from 2000-2002 and the absolute worst 2003-2006. Let’s establish an informal definition of recency bias with this first example à HYPOTHETICAL: You would have had recency bias in 1999/2000 by assuming that the Growth category would continue to outperform the overall market simply because of a previous 5-year trend of that being the case.

A PROBLEM: Not re-balancing

My goal is to drive home these two common and potential problems with investing in relation to just this 1st case study, BUT the concept should continue to make sense in the following examples even without specific illustration from me. Re-balancing would consist of “chopping gains” off of out-performing categories (or respective specific funds) and re-allocating these gains to recently under-performing categories at some point in time. This is one of the simplest ways to “buy low, sell high” which is commonly regarded as intelligent investment behavior, in a general sense.

With the assumptions of no re-balancing from 1995-1999 and starting off with 25% allocation to the 4 categories in YEAR 1, you are left with this basic breakdown at the end of 1999:

37.69% allocated to Growth

24.83% allocated to Growth & Income

21.09% allocated to Aggressive Growth

16.40% allocated Internationally

Consequently, you head into the 21st century significantly over-funded to the Growth category in which you experience the 3 following years of that being the 2nd worst category and 4 additional following years of Growth being the worst place to be. Experiencing these 7 years (2000-2006) with somewhere close to 25% in Growth to start would have meant a world of difference in comparison to almost 38% with no re-balancing at any point. Inversely, International out-performed U.S. Growth in 6 of those 7 years. Heading into this time period with only 16.40% allocation instead of somewhere close to 25% would have also been a mistake, essentially creating a double-edged sword.

Note: Growth & Income and Aggressive Growth also generally out-performed Growth from 2000-2006, for 7 out of the 7 years and 5 out of the 7 years, respectively.

AN EVEN BIGGER PROBLEM: Speculation

Never re-balancing would have been less drastic of a mistake in comparison to using recency bias to further fund the Growth category, sometime around the turn of the century. This bias would have told you to sell Growth & Income, Aggressive Growth, or International investments (or any combination of the 3) to invest additionally in Growth, due to the fact that these 3 significantly under-performed relative to Growth for a number of years. Since we can now look back in time, it’s easy to see how much of a mistake falling into this common trap as an undisciplined investor would have been.

Case Study 2

YEAR 1 – 1999

Investments made into account at 25% Growth, 25% Growth & Income, 25% Aggressive Growth & 25% International Allocation.

YEAR 5 – 2003

The Aggressive Growth category was highly volatile during this 5-year window (let’s define more intrinsically as ‘small growth stocks’ for this example).

1999 – 43.09% return, best of 4 categories

2000 – 22.43% loss, worst of 4

2001 – 9.23% loss, best of 4

2002 – 30.26% loss, worst of 4

2003 – 48.54% return, best of 4

For 5 straight years, the only definition of consistency here involves this category going from either “best place to be” to “worst place to be” or vice versa, throughout. Any decision that reasonably involved recency bias during this time period and with this category in particular would have likely resulted in a significant mistake!

Case Study 3

YEAR 1 – 2017

Investments made into account at 25% Growth, 25% Growth & Income, 25% Aggressive Growth & 25% International Allocation.

YEAR 6 – 2022

Growth was the best performing category for 5 straight years, from 2017 to the end of 2021. The market has struggled thus far in 2022 in a general sense, although some recovery being experienced in the past few weeks as of 03/29/2022. Out of the 4 most commonly used U.S. market indexes/indices, the NASDAQ Composite Index best represents the Growth category. For the majority of 2022, this index has been hit the hardest, sitting at nearly 15,833 on Jan. 3 all the way down to roughly 12,581 on March 14 (over 20% loss for this time period). As of mid-afternoon 03/29/2022, we are looking at significant recovery with this index alone, currently sitting in 14,550-14,560 range. With a harder initial downfall, on the reverse this specific recovery has been more drastic than with the other indexes/indices for the past few weeks.

Concluding thought à with the market being as widespread, large, and available as it is, combined with the advance of technology… it may be reasonable to conclude that these market shifts and cycles will continue to become more drastic in frequency and the level of loss or gain per whatever time period you are looking at, but less drastic with how long these shifts last… all the more reason to not speculate and potentially get burned by recency bias or some other investment-related negative behavior with something as important as saving for retirement or other goals over the long-term.

If you have any questions, please don’t hesitate to reach out to your personal Financial Advisor. If you are not currently a client of Whitaker-Myers Wealth Managers, we are always open to questions. You can use the chat feature on our site or reach out by phone/email to any of our advisors.

Author: Griffin Lusk

DISCLOSURE: Past performance does not guarantee and is not indicative of future results. There are limitations to using historical data and calculations, and trends in general are not implied to neither continue nor change. You can view the information used for these illustrations from the Prudential Periodic Table of Investment Returns here. See website disclosure for more information.