Nathaniel J. Tilton, CFP, AIF, Managing Principal and Wealth Advisor, Tilton Wealth Management.
When investors evaluate their portfolios, there is one factor that consistently outweighs them, and that is recent performance. Whether it’s a strong 12-month return or a disappointing quarter, investors base their decisions on what just happened. And while that tendency is human, it is one of the most destructive forces in long-term investing.
In my experience working with clients over the past 25 years, the biggest threat to a well-constructed portfolio is not market volatility. Rather, it is a tendency to overreact to recent results.
recency trap
We all know that capital markets do not move in straight lines, and performance over time is rarely evenly distributed. A portfolio that performed exceptionally well over the past 12 months may have benefited from a narrow set of circumstances – perhaps a concentrated position in a specific sector, a surge in a handful of stocks or a temporary macroeconomic tailwind. Those conditions, whether positive or negative, are not guaranteed to last. Yet investors often assume that they will do so.
Behavioral economists call this “recentness bias,” our tendency to give more importance to recent information when making decisions. In investing, this is seen when we chase what is working now and abandon what has not worked recently. Ironically, this behavior often leads investors to buy high and sell low. The exact opposite of what every investor wants to do.
When ‘good performance’ becomes a risk
The recent strong returns seem reassuring. They create a sense of confidence, perhaps even validation. But in many cases, they should insist on deep investigation rather than blind faith. Why? Because massive returns are often accompanied by increased concentration and elevated risk.
A retirement account that has performed significantly over the past year may be heavily tilted toward a specific asset class, sector, or style. That concentration may not be obvious at first glance, but it can introduce vulnerabilities that only become apparent when market conditions change later. What appears to be strength today may be weakness in disguise. Of course, this doesn’t mean that strong performance is inherently bad. It just needs to be understood in context.
Difference between result and process
One of the most important distinctions investors can make is the difference between outcome and process. The outcome is what happens, which is your return over a certain period of time. The process is how you get there, which examines the level of diversification, risk taken and whether the strategy aligns with long-term goals. A good result does not always reflect a good process. And a concrete process won’t always yield good short-term results.
The problem is that most investors evaluate their portfolios almost entirely based on results, especially recent results. This is where disciplined investing becomes difficult. This requires the ability to look at past short-term results and assess whether the underlying strategy still makes sense.
A better way to evaluate your portfolio
Instead of focusing on what your portfolio did over the past 12 months, consider whether your allocation is in line with your long-term goals and time horizon. Are you appropriately diversified or overly dependent on a narrow group of investments? How will this portfolio behave in different market environments? If recent winners perform poorly going forward, will you still be comfortable with your strategy?
This shifts the focus from your performance to your objective, which is a key factor for successful investing. Don’t think of your portfolio as a report card. It is a tool designed to help you achieve specific financial results. An investment portfolio is just one item to help you achieve your goals. Judging it only on the basis of recent performance is like evaluating a long-term plan on the basis of one chapter.
role of discipline
None of this is easy, which is why financial advisors play an important role as financial therapists. In my opinion, behavioral finance is much more important than choosing the best-performing large-cap mutual fund. It’s natural to feel uneasy when something you own is performing poorly or to be tempted to double down on what’s working. But successful investing often requires doing the opposite of what feels comfortable at the time. This may mean moving away from recent winners or investing in areas that have not performed well. These decisions don’t always feel right, but they are often necessary to maintain a disciplined, long-term approach.
final thoughts
Market volatility will continue and performance fluctuations are inevitable. There will always be a temptation to assess your portfolio based on what just happened. But when recent performance becomes the primary driver of decision making, even the best-laid plans can quickly go awry.
Investors who succeed over time are not the ones who chase what works or run away from what doesn’t work. It’s those people who stay focused on the process that should lead to great success in investing.
The information provided here is not investment, tax or financial advice. You should consult a licensed professional for advice regarding your specific situation.
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