Market Commentary - Q4 2020

January 2021

Market Recap

The fourth quarter of 2020 exhibited strong, broad based market performance. Throughout the year we have written about a small group of mega-cap stocks leading the market higher from the March lows. The divergence in performance, particularly in the largest U.S. tech stocks versus the rest of the market, reached historical extremes. The fourth quarter finally demonstrated broader participation from value stocks, international stocks (both developed and emerging), and small-cap stocks. 

While much of the recovery was driven by overwhelming monetary and fiscal stimulus, the most recent catalyst appears to be the arrival of a Covid-19 vaccine and the launch of a program to begin vaccinating Americans. The market laggards (i.e. value stocks) rallied sharply due to this news and regained some of the dispersion that had occurred vs. their growth stock counterpart. Even small company stocks in the U.S., which felt the brunt of the Covid-19 sell-off, rallied strongly to finish the year and were up over 30% for the quarter. On average, global stocks finished the year with double-digit returns.

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The Covid-19 sell-off in the first quarter of 2020 impacted virtually all asset classes. This included high quality corporate bonds which are typically stable. As the credit markets continued to heal, and liquidity dislocations began to improve as the Federal Reserve stepped in, the bond market experienced a substantial reversal finishing the year with solid performance. 
 

2020 – A Year for Endless Investor Behavioral Finance Biases

Analysis of behavioral biases as they relate to investing has grown in popularity over time. When human interaction is involved in decision making, emotions can impact outcomes. Understanding the effect of these emotions on decision making as it relates to investing, can help rationalize an overall investment process, in turn minimizing the emotional and cognitive impact on portfolio performance.  Due to the anomalistic performance of stocks in 2020, several key biases were on display, resulting in a year that will be studied and referenced by behavioral economists for years to come. We have written throughout the year about remaining disciplined while investing long-term. The importance of this core principle will be even more apparent as we describe a few of the common biases which impacted many investors this year.

In this Market Commentary, we explore a couple of cognitive biases that seemed to take center stage. When it comes to investing, decisions made in the present can have a ripple, or compounding, effect into the future. Understanding these biases and how to temper can help avoid common mistakes that could have generational consequences.
 

Recency Bias

This is perhaps the most important cognitive bias to overcome for many investors. Recency bias gives greater importance to the most recent event. In March, the sharp drop in stocks caused many investors to feel like the decline would continue thus leading many investors to sell out of stocks. Seasoned investors knew that the market would eventually stop selling off and start to recover. The sharp, unprecedented rally after the Covid-19 sell-off quickly helped investors forget the severe economic damage and resultant stock market sell-off. They could then focus on jumping back into stocks so as not to miss the run-up. To be sure, this year’s market was unlike any other in terms of the response from Washington and the Federal Reserve. As a result of the massive stimulus programs that were implemented, investors bought up stocks that just a few months prior seemed destined for bankruptcy.

The financial impact of allowing recency bias to drive decisions when it comes to ‘timing’ the market (or guess which direction the stock market is heading by adding to or taking money away from the market), can be detrimental and insurmountable. The graph below shows returns over the past 25 years and if an investor missed the 10 best days out of 6,300 days. No one knows when the worst days will happen as this would require seeing into the future. However, we do know that the best days typically follow the worst days.

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Recency bias not only impacts an investor’s attempt to ‘time’ the market it can also cause the wrong shift in the way a portfolio is invested. During the Dotcom Bubble of the late 90’s, many investors ignored expensive valuations on stocks and continued to allocate money towards these companies. As a result, many portfolios were overinvested in large U.S. technology stocks when the bubble popped. This flies in the face of the adage “buy low, sell high.”  
 

How we mitigate Recency Bias

Because recency bias favors recent events over historic ones, the best way to fight this bias is to keep a diversified portfolio of investments (see graph below) that will perform differently over various parts of the business/economic cycle. It is nearly impossible to predict the various fluctuations of a stock market with great precision, which is why using investments that respond to different macro/micro economic factors is critical to optimizing long-term portfolio returns. 

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Additionally, disciplined rebalancing sells when an allocation or particular investment grows beyond an acceptable level of risk. On the other hand, when an asset falls to a lower percentage of the portfolio, an investor would be adding to the asset. In March, a disciplined rebalancing strategy would have been to sell safer assets (like bonds and cash) and buy riskier assets (like stocks). Implementing this disciplined approach worked well in mitigating recency bias. 
 

Confirmation Bias

According to the American Psychological Association, confirmation bias is the tendency to look for information that supports, rather than rejects, one’s preconceptions, typically by interpreting evidence to confirm existing beliefs while rejecting or ignoring any conflicting data. This bias is stronger for emotionally charged issues or when beliefs are deeply entrenched, of which 2020 was the poster child.

When it comes to investing, the obvious result of falling prey to this bias can leave a portfolio invested in a manner that is influenced by one or two factors. Often a portfolio that has a strong confirmation bias is lacking in diversification. Investors tend to ignore the counterarguments to their investment case. In March, many investors, believing a depression was upon us, failed to seek out contrarian evidence such as inexpensive valuations and monetary and fiscal stimulus. 
 

How we mitigate Confirmation Bias

When seeking to avoid such errors, the process of seeking out and understanding opposite perspectives, using fundamental investment principles, and diversifying portfolios can be critical.  One of our core functions as investors is to analyze views which challenge ours. Our process also leads to diversifying portfolios which in effect serves as a strong mitigating factor against confirmation bias. 
 

Behavioral Biases Summary

The stock market can be a powerful wealth generating tool. It is the mechanism that allows small and large investors alike an opportunity to own a variety of businesses that produce various goods and services. However, the ability to see fluctuations in business values on a minute-by-minute basis can prompt poor decision-making emotional responses. These emotions are driven by cognitive biases; however, the recognition of these biases along with a disciplined approach to investing (focusing on the long-term, diversifying, and implementing fundamental research methods) can help avoid many of the traps investors have fallen into in the past.

We highlighted a few examples of behavioral biases seen in investing that were strong influencers in 2020, but this is certainly not an exhaustive list. There are dozens of other biases that can creep into investor psyche but below are a few more to note.
 
Bias Description
Information Bias Tendency to evaluate information even if it is useless to understanding a problem or issue.
Endowment Effect Tendency for a person to place a higher value on something currently owned than an identical good that is not owned.
Anchoring Bias Tendency to rely on one piece of information when making a decision.
Over-confidence Bias Tendency to exaggerate one’s ability and expertise.
Familiarity Bias Tendency to prefer what is familiar or well known.
Status Quo Bias Tendency to prefer things stay the same by doing nothing or sticking with a previously made decision.

Throughout 2021, we will expand on the behavioral finance side of investing to explain how a process driven, research focused, plan-oriented investment philosophy helps us side-step these cognitive biases in helping to achieve your long-term goals and objectives. 
 

Investment Strategy 

Equities: 

As we begin 2021, stocks have several strong tailwinds. The main driver may come from a global economy that continues to heal, supported by massive stimulus programs from Washington and accommodative interest rate policy from the Federal Reserve (with similar programs around the world). However, stocks are currently at a precarious intersection as it relates to various valuation metrics and the ability for companies to deliver profits needed to justify lofty prices. This reconciliation process will likely be the main risk driver for 2021.

Despite the lofty valuations for companies in the S&P 500 (particularly certain technology companies), we are finding much better valuations in some sectors of large U.S. stocks (like financials and industrial stocks) and in some sub-asset classes (like emerging market and small ‘value’ stocks). We believe diversification will be critical for success in a post Covid-19 world.
 

Fixed Income and Cash Equivalents:

By design, the Federal Reserve cut interest rates to the lowest they can go (without going negative) and will keep them there until at least 2022. This is to encourage investors to reduce cash holdings in favor of riskier investments (like bonds, stocks, and real estate). As a result, prices of bonds have gone up and yields offered on the bonds are much lower. The bond market performed very well during 2020 because of this phenomenon. However, future returns for bonds will likely be suboptimal for the foreseeable future. 

Interest rate risk, which is the risk associated with a bond’s price falling due to rising interest rates (remember, bond yields and prices have an inverse relationship), is on the forefront of our minds as we attempt to navigate a ZIRP (Zero Interest Rate Policy) world. We prefer to remain in bonds that have low interest rate risk and high credit quality to act as a ballast to the volatility often experienced with stocks. 

Cash, while very safe in terms of volatility, is a dangerous asset class as it relates to inflation-adjusted returns. Cash is currently paying approximately zero while the cost of goods (inflation) is increasing closer to 2%. The real return from this is accordingly negative.
 

One Final Note

Bloomberg ran a story recently entitled “It’s been a Great Year for Stocks and a Bear Market for Humans.” We agree wholeheartedly with this sentiment. As we enter 2021, we are invigorated by the human spirit and examples of resilience we witnessed last year. Most asset classes exhibited this same resilience and eventually recaptured and exceeded previous highs. Our process driven approach to investing portfolios on behalf of our client base was tested. Ultimately, it proved successful during one of the most tumultuous years in memory. While we are certainly hoping for a calmer 2021, we are prepared for the upcoming year with our time-tested approach. We thank you for your trust and confidence.