Recency effect investing in bonds

Recency bias in investing Recency bias is very common in investing; investors tend to give more importance to short term performance compared to long term performance. For example, an investor invests Rs , in a mutual fund. Over 5 years the market value of his investment grows to Rs , Then in the last three months, the value falls to Rs , The investor may look at his investment performance of as a loss of Rs 25, in 2 months and not an overall profit of Rs 50, in 5 years.

This is recency bias. Investors often stay away from equities when market has fallen sharply when on the contrary, they should be investing because they can buy further at attractive prices. Recency bias clouds our judgment and is detrimental to our financial interests in the long term. How to avoid recency bias Understand how market works:Equity markets always work in cycles.

There are periods when prices go up bull market and there are periods when prices fall bear market. Markets eventually recover from the lows and goes on to make a new peak, higher than the previous one. Rs , invested in the Sensex 20 years back, despite several bear markets, would have grown to Rs , as on 30th July Invest according to your financial goals:You should clearly define your financial goals and invest accordingly.

You should have a financial plan to meet your different goals — short term, medium term and long term. You should always stick to your financial plan. Goal based investing will keep you disciplined and not get affected by recent events in the market. For example, a recent survey of retail investors by State Street found that they were mostly invested in cash.

They had 31 per cent of total assets in cash and expected to be 30 per cent invested in cash in 10 years time. This was in spite of widespread recognition that they needed to be more aggressive. We can put much of this preference for safety down to recency bias. Sometimes, a bias to recency has no ill effect.

The trouble is momentum does not work all the time; occasionally markets overreact, assets become over- or -undervalued, before at some point reverting back towards their historical averages. We should accept that our decision making can become fogged during these transitional phases.

Certainly, recency bias helps to explain why it can take a while for many investors to react to genuine turning points in the market. So what can investors do to avoid the trap of recent events dominating their thinking?

One solution lies in the application of systematic rules. Investment professionals have long recognised that a consistent, research-driven investment process is a valuable defence against psychological biases. In the case of recency, deliberate consideration of a longer time horizon or data set helps to put the present environment into context.

For example, historic average valuations can guide our view on the present value of financial assets. Put the present into a wider context Graph 1 shows how far yields in financial assets are from their year averages. Equities come out cheapest — the yields on non-financial equities are above average and the most attractive versus their own history. That attraction becomes more persuasive when you look elsewhere — cash and bonds are yielding significantly below their respective year averages.

Indeed, the expensiveness of government bonds is quite extreme. In statistical terms, current yields are said to be over 2 standard deviations below their 10 year average. Another way of saying this is that over 95 per cent of government bond yield values over the last decade fell within a range that was higher than the current yield on government bonds.

Longer-term investors who believe in mean reversion may want to review the equity, bond and cash weights in their portfolios. Another defence against recency bias is careful exposure to financial media. The impact of recency can be exaggerated by media coverage and our bias to another psychological effect called narrative fallacy. This means we are highly susceptible to stories — so much so, that we look for patterns and explanations where there may only be randomness.

Every twist and turn in the market is attributed to something or someone.

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If I am correct, our focus should be on avoiding deflation and not inflation. I have therefore recommended to purchase long duration government bonds. The average spread between the year and core inflation since is 2. The spread today with the year yield close to 2. Low yields today are only expressing the view that there will be little or no inflation in the coming years. I will stand by this view as I still see no reason for inflation expectations to rise.

As we approach my target, some readers have asked whether I believe yields could march significantly below that level. I suppose so, however, I am coming to believe that this is not the wish of the Fed, and remember that the Fed has complete control on the yield curve. How Currency Fluctuations Affect Total Returns A slide in the currency in which your bond is denominated will lower total returns. Conversely, an appreciation in the currency will further boost returns from holding the bond — the icing on the cake, so to speak.

Consider a U. The euro was flying high at the time, with an exchange rate versus the U. Unfortunately, by the time the bond matured a year later, the euro had fallen to 1. The investor may have initially purchased the bond because it had a three percent yield, while comparable U. The investor may also have assumed that the exchange rate would stay reasonably stable over the bond's one-year holding period.

In this case, the positive yield differential of two-percent offered by the euro bond did not justify the currency risk assumed by the U. This equates to a loss of approximately Of course, the euro could as well have gone the other way. If it had appreciated to a level of 1. Hedging Currency Risk in Bond Holdings Many international fund managers hedge currency risk rather than take the chance of returns being decimated by adverse currency fluctuations. However, hedging itself carries a degree of risk since a cost is attached to it.

As the cost of hedging currency risk is largely based on interest rate differentials, it can offset a substantial part of the higher interest rate offered by the foreign currency bond, thereby undermining the rationale for investing in such a bond in the first place. Depending on the method of hedging employed, the investor may be locked into a rate even if the foreign currency appreciates, and incurring an opportunity cost as a result.

In a number of cases, however, hedging may be well worth it either to lock in currency gains or protect against a sliding currency. The most common methods employed to hedge currency risk are currency forwards and futures, or currency options. Each method of hedging has distinct advantages and disadvantages.

Currency forwards can be tailored to a specific amount and maturity but lock in a fixed rate, while currency futures offer high leverage but are only available in fixed contract sizes and maturities. Currency options provide more flexibility than forwards and futures but can be quite expensive.

The Bottom Line Foreign bonds may offer higher yields than domestic bonds and diversify the portfolio. However, these benefits should be weighed against the risk of loss from unfavorable foreign exchange moves, which can have a significant negative impact on total returns from foreign bonds.