All Risk Assets Experience Long Periods of Poor PerformanceAll Risk Assets Experience Long Periods of Poor Performance
What you don’t know about investing is the investment history you don’t know.
February 25, 2025
Buying after periods of strong performance (when valuations are higher and expected returns are now lower) and selling after periods of poor performance (when valuations are lower and expected returns are higher) is not a prescription for successful investing.
Yet many individuals invest because of recency bias—the tendency to overweight recent events/trends, projecting them into the future while ignoring long-term evidence—and this is how they do it. Disciplined investors do the opposite. They rebalance to maintain their well-thought-out allocation to risky assets.
Avoiding recency bias requires investors to have sufficient patience to maintain discipline, staying the course through periods of poor performance. Recency bias also causes investors to ignore historical evidence, which makes it clear that all risk assets go through long periods of poor performance. Such periods are not a reason to avoid a risky asset. Instead, they are a reason to diversify to avoid having all or most of our eggs in the wrong basket.
Recency Bias
The following table shows the annualized returns of the major global equity asset classes over the last 17 years (2008-2024). The superior performance of the large cap S&P 500 Index has led many investors to question the wisdom of diversifying portfolios to include international and emerging markets and U.S. small and value stocks.
Before you succumb to recency bias, consider how the investment world looked on January 1, 2008. The table below shows the annualized returns of the same major global asset classes over the prior eight-year period, 2000-07.
Over this period, the S&P 500 was the worst-performing equity asset class, with emerging markets being the best. In addition, small and value stocks far outperformed the large cap S&P 500 Index.
However, we need to consider how the investment world looked to investors subject to recency bias on January 1, 2000. The table below shows the annualized returns of the major global equity asset classes over the 1995-1999 period.
Investors subject to recency bias would have been buyers of the S&P 500, which went on to be the worst performer in the next regime (2000-07) and would have avoided U.S. small-value stocks and especially emerging market stocks, which turned out to be the best performers.
The following two examples provide powerful evidence of the importance of understanding that all risk assets experience long periods of poor performance. As the following chart illustrates, the S&P 500 Index has experienced three periods of at least 13 years when it underperformed riskless one-month Treasury bills.
Those three periods total 45 of the last 96 years (47% of the period). Of course, that means it provided spectacular returns in the other 51 years. However, investors would have been able to earn those great returns only if they avoided recency bias and stayed the course. The most famous example of recency bias is perhaps the 1979 cover of BusinessWeek titled "The Death of Equities."
It is also worth noting that each of the periods preceding the above three were periods of very strong performance for the S&P 500, fueled by multiple expansions (as has been the case over the past 17 years). Those who don’t know their history are doomed to repeat mistakes.
The last example is even more powerful as it covers the 40-year period 1969-2008. Note that over those 40 years, the best performers over the last 17 years underperformed U.S. long-term government bonds (20-year maturity), which is the riskless investment for pension plans with nominal long-term obligations (such as pensions).
Valuations Matter
As noted earlier, multiple expansions often fuel superior performance, resulting in the outperformers having much higher valuations and, thus, lower expected returns. With that in mind, let’s look at the current relative valuations of US and international stocks. As you can see, the earnings yield (E/P) of the Shiller CAPE 10 (cyclically-adjusted price-earnings ratio), which is the best predictor we have of future long-term real returns, is just 2.7% for the U.S., but is 5.5% for the stocks in the EAFE Index, and 7.1% for emerging market stocks.
Similarly, the relative outperformance of large U.S. stocks has resulted in their valuations relative to small-value stocks being near historical peaks. Prior peaks, such as what occurred in March 2000, have presaged future large value premiums. The result is that investors should expect that going forward, the small value premium is likely to be larger than the historical average.
Investor Takeaways
Recency bias makes us forget the lessons history provides. First, superior performance is often driven mostly by multiple expansions, leading to high valuations and lower future expected returns. Those subject to recency bias are instead expecting future returns to look like the recent past. The second lesson is that the historical evidence demonstrates that trying to time these shifts in regimes has been a loser’s game for active managers. Thus, the winning strategy is to stay disciplined, buying after periods of poor performance when expected returns are now higher and selling after periods of superior performance when expected returns are now lower.
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