When Great Expectations Are Counterproductive
Once again, we are indebted to Jason Zweig of the Wall Street Journal—this time for calling our attention to a recent survey of 750 U.S. individual investors with at least $100,000 of investable assets conducted by Natixis Investment Managers. The average expected long-term future return of the surveyed investors was an unbelievable 17.5% above inflation! Holy pie in the sky, Batman!
The study contrasts the 17.5% with a 6.7% post-inflation return expected by financial professionals (which we believe is too high as well). Since, 1926, U.S. stocks have returned a little over 10% before inflation or about 7% after. These numbers reflect a long-term increase in valuations (price paid per dollar of earnings) that we do not expect to repeat going forward.
There are several behavioral finance phenomena that explain these investors’ wildly optimistic expected returns. The first is recency bias, our natural tendency to assign more importance to recent events over historic ones. As of mid-year, the S&P 500 Index has returned 18.7% annually over three years and 17.6% over five years. The survey respondents are clearly extrapolating the recent past into the future.
The second is overconfidence, a charming attribute of Lake Wobegon where all the children are above average. Even if they don’t expect the rest of us mopes to get anything near 17.5%, these investors believe that either Providence is smiling upon them or they possess some extraordinary talent that will propel their portfolios “to the moon” as the meme stock speculators like to say.
We believe that the third one is selective memory bias, the tendency to remember our winning stock picks while forgetting about the losers. It also refers to the tendency to attribute the former to skill and the latter to bad luck resulting from things that are out of our control (e.g., the impact of the pandemic on cruise ship stocks). As Zweig points out, much of the outperformance of the market indexes derives from a relatively small number of names (e.g., Tesla up 59.1% annually over the last ten years), and investors who happened to own even one of these stocks could easily convince themselves that they will replicate that performance going forward. Zweig also notes that some of the great performers, rather than producing an excellent and exciting product like Tesla, are dull companies that were hanging by a thread, as Domino’s Pizza was in November 2008 at $3/share. It last traded at over $476 as of this writing. Other high-fliers are companies you have likely never heard of like Patrick Industries, a manufacturer of components for recreational vehicles.
In this sea of unrealistic expectations, there remains an island of sanity—the investors in the Vanguard funds. The researchers at Vanguard found their investors (including both individual retail clients and retirement plan participants, surveyed bimonthly) to have an average 10-year expected return of 6% (including inflation) as of December 2020. Interestingly, their expected return ticked upward during the COVID drop of 2020 but fell back after the subsequent recovery, indicating awareness of the basic economic principle that the expected return of a financial asset is inversely proportional to the price paid for it. It should be noted that the study does not reflect the general investor population because Vanguard investors tend to understand the importance of asset allocation, broad market diversification, keeping costs low, and staying the course during high volatility, as opposed to stock-picking, market timing, and frequent, panicky trading. We believe there are other companies that attract knowledgeable and well-behaved investors like Avantis Investors and Dimensional Fund Advisors.
Regarding the title of this article, having overly high expectations can lead investors to forego saving. After all, why should they bother saving an extra few percent of their salary if they can double their money every four years? Likewise, investors in the decumulation phase (retirees) would be tempted to spend more than is prudent. If you would like to learn more about what we consider realistic expectations for the capital markets, please reach out to us.