If you had to put $10,000 of your cash savings into an investment vehicle today, how would you choose? There’s no guaranteed right or wrong answer with the exact investment, but the strategy investors use when making this decision is where they can go wrong. Taking cognitive shortcuts or falling into common biases is human nature, but there are strategies that enable investors to avoid thoughtlessly joining the herd.
The Bias Of Today’s Market Performance
The S&P 500 Communication Services index has enjoyed a strong 2024, following a 56% gain in 2023. Comparatively, the S&P 500 Information Technology index, which enjoyed a 58% runup in 2023, has lagged a bit behind the Communication Services in 2024. However, both these technology-heavy sectors have outperformed the broader S&P 500 in 2024 (as of the date this article was published).
The macro analysis is that tech has ruled the markets for the past few years, primarily because of a booming artificial intelligence (AI) revolution and tools such as semiconductor chips in demand to fuel it.
After years of seeing just a few companies continue to drive the market higher, some retirement planners or investors may find this to be justification for a tech-only investment approach. However, are there legitimate economic reasons to own smaller and middle-sized companies as well as other market sectors when technology seems to be the major driving force for returns? Some investors argue that yes, the broader market makes more sense now as they question whether the tech tide could be turning.
Other investors argue that it’s not the tech tide turning so much as it’s finally time for the broader market to play catch up with these high-flying sectors. For investors, this is known as a reversion to the mean.
Reversion To The Mean
Commonly credited to the vast teachings of 2013 Nobel prize winner Eugene Fama and the principles of the Efficient Market Hypothesis, mean reversion refers to the idea that market prices and returns eventually gravitate toward their historical averages. In other words, once a part of the market gets hot for too long, it often needs time to cool, which gives less popular areas their day in the sun. The concept warns against timing the market because it’s difficult to predict when a reversion will occur.
This phenomenon exists across the investing world. Take, for example, allocating 401(k) mutual funds. A common strategy employed by young, inexperienced folks making their future retirement choice is the “What’s Already Done Well” outlook—selecting recently soaring stocks or fruitful funds and assuming gains will continue. Unfortunately, disappointing results often follow. The ascendant slope of these funds decreases, and the ones ignored pick up the pace. The perceived winners rotate to losers. Simply put, what did well before doesn’t always mean it will do well forever, and a reversion to the mean generates the opposite of the investor’s desired effect.
This phenomenon exists all across the investing world. Take, for example, allocating 401(k) mutual funds. A common strategy employed by young, inexperienced folks making their future retirement choice is the “What’s Already Done Well” outlook—selecting recently soaring stocks or fruitful funds and assuming gains will continue. Unfortunately, disappointing results often follow. The ascendant slope of these funds decreases, and the ones ignored pick up the pace. The perceived winners rotate to losers. Simply put, what did well before doesn’t do well forever, and a reversion to the mean generates the opposite of the investor’s desired effect.
Cognitive Shortcuts
To seek and value an asset simply because it has recently prospered is a common mistake. Most investors aren’t financial experts, and the human mind tends to operate through a series of heuristics, or cognitive shortcuts, to simplify the decision-making process. The investor picks the prosperous funds, relying on an immediate and perceived practical solution. The world is far too complex for an exhaustive analysis of every daily decision, and heuristics are helpful, even essential, for avoiding mental paralysis. However, the downside is that their utilization can lead to bias.
Recency Bias
Recency bias is the tendency to put too much emphasis on the latest events—seeing a news report about a plane crash and deciding it’s not safe to fly. Likewise, investing in stocks or funds because they have recently boomed prioritizes short-term performance rather than long-term averages. Is there a chance this could work? Sure. But, over time, recency bias can lead to unwise decisions and problematic results.
It can even create herd behavior, which British economist John Maynard Keynes felt was a response to uncertainty and self-perceptions of ignorance. In other words, people might follow the crowd because they incorrectly assume it’s better informed. In financial markets, such behavior can generate instability and usher in speculative episodes like the dot-com bubble.
Confirmation Bias
Confirmation bias is the propensity to search for, interpret, and remember information that corroborates previously held beliefs. For instance, someone who believes semiconductors are the new gold might pursue like-minded opinions and then cite those sources as proof.
This proclivity again relates to the “What’s Already Done Well” investor. Rather than making balanced choices based on long-term historical trends, this person zooms in on a six-month winning streak.
Rebalancing The Bottom Line
In today’s market, it’s very tempting to abandon non-tech equities, but that approach could be short-sighted. Market history points to a likely reversion of the mean, leading to profitable manifestations in other segments of the investing landscape.
One way to combat bias is to rebalance—sell a portion of the outperforming sectors and reinvest in the underperforming ones to restore a more balanced equity allocation. Selling high and buying low counteracts the natural human impulse to chase recent winners.
While rebalancing’s precise impact on overall returns is difficult to quantify, its value lies in practicing disciplined, long-term investing. By consistently adjusting your portfolio to help maintain symmetry, you could not only spread risk but also take advantage of market inefficiencies—buying undervalued sectors and selling overvalued ones. Currently, the potential for rebalancing seems most relevant when discussing tech stocks vs. utilities. Still, it could also apply when considering stocks vs. bonds, large vs. small cap, and many other market scenarios.
The urge to join the herd and stampede toward immediate trends is natural and human but not necessarily always productive for investing. Rebalancing can help people resist following the crowd and instead focus on maintaining a well-diversified, balanced portfolio that has contributed to sufficient nest eggs for many happy retirees.
This information is provided to you as a resource for informational purposes only and is not to be viewed as investment advice or recommendations. Investing involves risk, including the possible loss of principal. There is no guarantee offered that investment return, yield, or performance will be achieved. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. For stocks paying dividends, dividends are not guaranteed, and can increase, decrease, or be eliminated without notice. Fixed-income securities involve interest rate, credit, inflation, and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed-income securities falls. Past performance is not indicative of future results when considering any investment vehicle. This information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. There are many aspects and criteria that must be examined and considered before investing. Investment decisions should not be made solely based on information contained in this article. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax, or investment advisor before making any investment/tax/estate/financial planning considerations or decisions. The information contained in the article is strictly an opinion and it is not known whether the strategies will be successful. The views and opinions expressed are for educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions.
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