Headlines for newspaper items and blog posts are troublesome things. They have always sold papers, particularly tabloids, but the advent of the web and search engines have made their importance, and the temptations to play games with them, even greater. The coin of this realm is the click, and if you want to get surfers to read your stuff you better have a catchy title, preferably including some popular search terms.
Earlier this month The Washington Post blamed an increase in typos (e.g. soldiers wearing "shiny black boats" on their feet) on copy editors being distracted by new duties. "Separate online headlines must be written in a way that attracts attention on the Web."
I bring this up because the other week Jason Zweig’s Intelligent Investor column in The Wall Street Journal was headlined "Why Many Investors Keep Fooling Themselves." (Mysteriously, the metatitle, the thing that appears at the top of the browser window, hedged: "Why Some Investors May Be Fooling Themselves.")
It is a good column, worth reading, but it disappointed me for the simple reason that it failed to discuss, even in passing, why many investors keep fooling themselves. It did cover the fact that they do keep fooling themselves, and touched a little on how, but didn’t attempt an answer to what I consider to be the really interesting part, why.
Zweig tells us that "a nationwide survey last year found that investors expect the U.S. stock market to return an annual average of 13.7% over the next 10 years." Personally, I consider that to be crazy optimistic. Average returns for the S&P over the decade just ended were –0.95%. Then again, the 80′s and 90′s averaged 17.55% and 18.21% respectively, so this particular bit of mass hysteria may not be entirely hallucinatory.
Still, it is a big number that few professionals would say out loud even if they thought it to be true. But, as it turns out, presumably sophisticated investors who should know better tend toward the same delusions.
Zweig cites another survey that an investment manager for endowments does of his clients. He asks them what is the least amount of guaranteed return above inflation they would accept as a swap for their actual returns over the next 50 years. In other words, at how low a rate would they be willing to lock in returns in exchange for not taking the risk of investing in things like stocks, bonds, and real estate?
Last year the average answer from this survey was 7.4% over inflation. Add inflation back in, and consider that these endowments would typically have significant bond holdings, and it is clear that these trustees are no less optimistic about stocks than the ordinary folks.
The thing is, locking in a risk-free return for the next few decades, even an inflation protected one, is not just a hypothetical possibility. Anybody can do it. Just buy a Treasury bond. The one maturing in November 2039 will pay you 4.54%, guaranteed. Worried about inflation? There are also TIPS. The longest dated one that I could find, maturing in April 2032, will get you inflation plus 1.98%.
That these endowment managers would only be willing to lock in returns at a number that is far above the actual market clearing going rate for such things can only mean that they are aggressively optimistic. They would not put it this way, but they are essentially arguing that the marketplace is wrong, that it has mispriced risk-free returns in light of the fabulous opportunities available in risky assets. In other words, you would have to be a lunatic to buy a long-term Treasury.
There are serious problems with that point of view, amongst them that the number of Treasuries in circulation is inconceivably large, exceeding even the supply of crazy people with money to invest.
Alternatively, you could believe that the risk-free rates were correct and that the higher returns you expect on risky assets are appropriate given the volatility you are taking on. But the numbers don’t really work.
The zero coupon Treasury maturing in February 2020 currently yields close to 4%. If you believed that 13.7% was the expected return for the S&P over the same period, and that the annual volatility of the S&P was 15.4% (its historical average since 1970) then you would be able to calculate that the probability of the S&P beating the Treasury over the next ten years is 99.9992%. So you get another 9.7% a year in expected returns in exchange for living with that scary 0.0008% risk that the risk-free bond might turn out to be a better deal? Not likely.
No, the bottom line is that although we can all agree that risk is a bad thing, and that in the abstract we would prefer not to have it and even to pay others to take it away from us, optimism about the future keeps getting in our way. Those endowment managers are not interested in paying to have the risk removed from their lives. In fact, they would need to be paid quite handsomely to give up the fabulous upside potential of uncertain returns.
Which is to say that they think they will get lucky. It is exactly the same triumph of emotion over logic that we see with the old index fund vs. actively managed fund question. It is easy to demonstrate that in the long run the average actively managed fund must underperform a low-fee index fund. And yet actively managed funds are much more popular. Why? Because few investors think that their active fund will turn out to be merely average.
I do not have a clever explanation as to why investors keep fooling themselves. (Sorry to disappoint.) But it is clear to me that it is in our basic nature as humans to do so. We have an optimistic bias when it comes to our expectations of the future. There is probably a good biological and evolutionary justification for that. If we were consistently and soberly risk adverse we would probably still be living in caves.
Evolution aside, this is still another example of non-logical reasoning that should be kept far away from money decisions. As Zweig puts it
The faith in fancifully high returns isn’t just a harmless fairy tale. It leads many people to save too little, in hopes that the markets will bail them out. It leaves others to chase hot performance that cannot last. The end result of fairy-tale expectations, whether you invest for yourself or with the help of a financial adviser, will be a huge shortfall in wealth late in life, and more years working rather than putting your feet up in retirement.