Quarterly Perspectives



Think Twice Before Changing Lanes

Traffic is an inevitable part of urban American life as those of us who frequent highways in Greater Boston or most other metropolitan areas know all too well. Apologies for raising an irritating topic, but we feel there are useful parallels to be drawn between driving and investment decision-making.

Perception in both realms is often distinct from reality as emotion can distort our interpretation of information. How often on traffic choked highways have you observed the adjoining lane appear to be less congested and changed lanes only to quickly come to a stop as those previously behind you move ahead? Social scientists have studied the phenomenon and offer a compelling rationale.

When assessing the lane to our left or right while stopped or travelling very slowly, people tend to focus their attention forward and overly emphasize a very temporary or even insignificant perception that others are advancing more rapidly. The inference is that drivers are responding to somewhat of an illusion; namely, that the next lane on a congested road is preferable even when traffic flow over a more meaningful period averages the same speed.

The punch line is that impulsive, reactionary moves are often counterproductive. As wealth advisors, we stress this to clients but fully recognize that emotion makes us human, and it isn’t always easy to stay put when experiencing market related stress. Let’s look at a couple of psychological explanations for why some are prone to abruptly switch lanes and/or asset allocation strategies.

Recency bias is a cognitive tendency to place much more emphasis on recent events than past ones regardless of their relative significance. When driving, you are likely to overweight the most recent thing you see, specifically cars passing you to the right or left, and believe that is likely to continue. When investing, people often overvalue short-term performance trends, which is why asset flows typically gravitate towards “hot” mutual funds, stocks, or sectors. Chasing cars or performance is not advisable as it may be illusory and risks backfiring. The reason is that more cars moving towards one lane itself generates traffic slowing congestion, just as performance chasing can introduce greater risk by inflating valuations to the point where a subsequent sell-off becomes more likely.

Whether recognized or not, many of our daily decisions factor in expectations of risk relative to anticipated benefit or return. That’s why we develop asset allocation and portfolio strategies with a clear sense of both a client’s goals and their willingness and ability to accept risk. Overreacting to short term developments without fundamentally based rationale, whether by joining the herd or by impulsively selling during unsettled times, can create opportunity cost (foregone market gains) or portfolio risk (loss of capital). A prominent academic study offers confirming evidence of that point, finding that over a 26-year period average 3-year forward mutual fund returns were inversely related to the same funds’ prior 3-year performance decile. In other words, there is a meaningful cost to chasing what appears to be the hot performer.1

Unfortunately, risk analogies also apply to our highways as data suggests that jumping off course can result in much more severe potential consequences than traffic. Even if one is to assume that lane changers get to their destination a little sooner, is it worth the risk? Perhaps not. According to Insurance Information Institute, reckless lane changes create 9% of all US accidents and directly factor into the deaths of 6,000 drivers annually.2

By no means are we suggesting that asset allocation ought to be on autopilot. Active management drives our investment process, and we will make portfolio adjustments as market conditions change and opportunities present themselves. We believe that wealth management ought to be highly personalized and recognize that individual needs and objectives evolve over time. The distinction we make, though, is between impulsive and well-grounded, fundamentally sound decisions.

Think about it in terms of the difference between relying on roadside traffic intelligence provided by Waze and reacting in frustration to what you momentarily see on the highway to one side or another. When risk tolerance, income needs, tax situations, or liability planning changes, portfolio strategy may need to adjust in response. But we rely on factors of that nature to make decisions as opposed to being overly influenced by daily market prognostication. The dynamics of fear and greed that often characterize investor behavior are somewhat analogous to the frustration and envy that drivers experience when battling their way to their destination.

Traffic patterns and markets can be unpredictable, yet in both contexts a steady path is typically more effective in getting from Point A to Point B. As Portfolio Managers, we have the responsibility of developing investment strategies that give each client the best opportunity to achieve their personal financial objectives, and to do so in a risk conscious manner. Course corrections are sometimes needed, but they ought to be based on more than momentary emotion.


This commentary reflects the opinions of Appleton Partners based on information that we believe to be reliable. It is intended for informational purposes only, and not to suggest any specific performance or results, nor should it be considered investment, financial, tax or other professional advice. It is not an offer or solicitation. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor. While the Adviser believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information.  Specific securities identified and described may or may not be held in portfolios managed by the Adviser and do not represent all of the securities purchased, sold, or recommended for advisory clients. The reader should not assume that investments in the securities identified and discussed are, were or will be profitable. Any securities identified were selected for illustrative purposes only, as a vehicle for demonstrating investment analysis and decision making. Investment process, strategies, philosophies, allocations, performance composition, target characteristics and other parameters are current as of the date indicated and are subject to change without prior notice. Registration with the SEC should not be construed as an endorsement or an indicator of investment skill acumen or experience. Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal.
"Many years in the equity markets are characterized by a prevailing theme or development, at times something dramatic such as the dot com frenzy of 1999 or the subprime mortgage meltdown of 2007 and 2008 that launched the Great Financial Crisis..."
"The recent passing of legendary investor Charlie Munger has prompted many prominent investors to publicly reflect upon his wisdom. The human element was often central to Munger’s insights concerning investment decision-making, and he was a pioneer in the field of behavioral finance."
“Atisa Dipamkara, a revered 11th century Buddhist philosopher, once said, “The greatest wisdom is seeing through appearances.” His insight into looking beyond first impressions resonates in today’s investment world. While diversification has long been touted as a means of mitigating risk, we recognize that it is far from solely determined by the number of securities held in an index or portfolio.”