Perspective on global equity markets through a behavioral finance lens

Don’t get burned by the “hot hand”

October 2016

Key takeaways:

  • Hot-hand fallacy, cognitive dissonance, and confirmation bias can create a desire to maintain a previously successful strategy well beyond when fundamental valuations might otherwise suggest.
  • Baby boomers may potentially be more susceptible to these behavioral finance precepts than millennials and Generation X.
  • Valuations on high-yielding stocks may have become overstretched in the historically low-yield environment, potentially making them vulnerable if the markets experience a mean reversion shift.
  • Growth returned to favor in early September, a potential harbinger for what historical valuations would argue is an overdue correction in high-yielding stocks.
  • Ensuring that hot-hand fallacy, cognitive dissonance, and confirmation bias are not disproportionately leading a portfolio’s overall allocations astray may become increasingly important as the current environment evolves.

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.

An unconventional environment

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.

Central Bank Quarterly Purchases

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.

Robust demand for dividend-paying strategies

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.

S&P 500 Index vs. sector performance

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.

Baby boomers should tread lightly

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.

Less risk for millennials and Generation X

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.

Potentially troubled waters ahead

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.

The S&P 500 Index generated a comparatively lower return than the S&P 500 Dividend Aristocrats Index

On the horizon

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.

Omar Aguilar, PhD
Chief Investment Officer, Equities and Multi-Asset Strategies
Charles Schwab Investment Management
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