Foolish Investors Make Foolish Predictions

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 NYSE floor Old - Crop 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.

No Comments

  • By Rick Francis, January 25, 2010 @ 3:14 pm

    I can’t see the current fixed rates getting most people to their goals. I WOULD have to be a lunatic to take inflation + 2% for my entire portfolio today because I could never retire! If I could get inflation + 4% I would start to think about it… There would be no early retirement but I my retirement would be certain as long as I can keep working and contributing. Inflation +7% I would take in a heartbeat.
    Even though I can’t go 100% treasuries I do think that some % of the portfolio in treasuries isn’t a bad idea for either short term or inflation protected treasuries.

    -Rick Francis

  • By bex, January 25, 2010 @ 3:58 pm

    I think the point is that unless you are comfortable with just getting inflation +2%, maybe you should re-think how much $$$ you’ll have in retirement…

    Everybody says you should save 20% of your paycheck every month for a comfortable retirement. If you made on average $50k per year, saved $10k, and invested in T-Bills earning 5%, you’d wind up with $1.25 million after 40 years… which should be sufficient for retirement.

    The reason people hope for better returns is simple: they think that they don’t have to save 20%… and they’ve inflated their lifestyle to the point where it’s too painful to cut back.

    So, they delude themselves into thinking that stock market returns are guaranteed at over 10%, and that there’s never a bear market.

  • By RetirementInvestingToday, January 25, 2010 @ 4:39 pm

    Great article. It really does amaze me how some people work and think. Surely a quick historical check would show that the S&P 500 or it’s equivalent has shown a real (after inflation) CAGR of around 6.5% since 1871 to today. That type of information is feely available on blogs or other websites. Some people really do bury their head in the sand.

    Personally, I’m running a retirement investing portfolio that is a mix of equities, gold, property, fixed interest and cash. I’m also using some techniques to try and place long term values on the stock market so that I can be under of overweight depending on the business cycle. My current asset allocation is suggesting a current average return based on historic data of 4.1%.

  • By mwarden, January 25, 2010 @ 8:02 pm

    Investment managers need to fool themselves, or else their value proposition is destroyed. My mom’s “financial advisor” has a quarterly meeting where pretty much the only thing he goes over is: her return minus his fixed fee is greater than the return of the S&P 500. (Absent, of course, is any measure of the extra risk to which he is exposing my mother.)

    “Financial advisors” have an incentive to take crazy risks, because even if something has only a 1% chance of beating the market and a 99% chance of total loss, that improves the likelihood of retaining the client from 0% to 1%!

    They can’t not take risks, or they will lose the client. And they do not care about downside risk, because (1) investing in an index fund. and (2) total balance loss both result in the same downside for the “advisor”: 1 lost client. If #2 provides a higher chance of retaining the client, then (s)he has incentive to pick #2.

  • By Parker Bohn, January 25, 2010 @ 9:33 pm

    A related question…

    Is it foolish for me to believe that I can beat the market?

  • By ps, January 25, 2010 @ 11:40 pm

    So, if one believes the upshot of the article – that many investors are stupid and too optimistic – what steps can one take to take advantage of that knowledge? What are effective ways that we cash in on the stupidity/over-optimism of most investors?

  • By Frank Curmudgeon, January 26, 2010 @ 12:30 pm

    Parker: Yes.

    ps: I think the best thing is to work to avoid your own stupidity/over-optimism. As for taking advantage of this in others, there are many ways. Value investing, for example, takes as its premise that the high-flying growth stocks are over-hyped and over-priced due to an excess of optimism.

  • By Rick Francis, January 26, 2010 @ 2:40 pm

    In 40 years $1.25 Million will NOT be even close to enough to live on because of inflation.

    If we assume your 50K/year worker’s salary increases with inflation and inflation were 3.5% every year for the next 40 years your worker would end up with $2.16 Million…

    Sounds like a lot but that $2.16 Million only provides income equivalent to $21,800/year today.

    He was used to saving 10K and living on $40K so that’s almost a 50% pay cut on his take home pay! Hopefully social security and Medicare still exist as he is going to need them.

    That nest egg is going to be completely gone in 32 years, so he better not live too long either.

    If your worker hadn’t been contributing for a full 40 years he is really in trouble… 30 years he would have just over $1 Million so his salary is the equivalent of $10,700 – just under the poverty line for a single person.

    -Rick Francis

  • By Parker Bohn, January 26, 2010 @ 6:02 pm

    You answered that it was foolish for me to think I could beat the market.

    Obviously, it is foolish for YOU to think I can beat the market. I’m just some guy as far as you’re concerned, and the average investor can’t beat the market.

    Let me ask another question. Is it foolish for me to believe that I can, say, beat other people at chess?

  • By Frank Curmudgeon, January 27, 2010 @ 7:32 pm

    Oh, you are just too clever for me. I guess you can beat the market, for all I know. Most people can’t. In fact, in my experience, most people who do it for a living can’t.

  • By Parker Bohn, January 28, 2010 @ 2:25 am

    Yeah, I’m being snarky :P

    I guess I’m trying to deal with the inherent contradiction in my simultaneous beliefs that:

    A) Like you pointed out in this post, most people are overconfident in their expectations.
    B) I believe I can beat the market.

    What I’m trying to figure out is, what needs to exist for a person to rationally believe that they can beat the market?

    (btw, two thumbs up for your blog. I don’t always agree with your take on things, but your viewpoints are always genuine and logical, and not just recycled blogosphere pap.)

  • By BRETT LOUKEDIS, March 19, 2012 @ 7:36 am

    I know I am commenting on this article a bit late but I couldn’t agree more with the analysis given by the author – stock market is a hard thing to predict that’s the reason I keep my portfolio balanced with annuities & stocks – I buy annuities with Bankers Life and Casualty Company – they have good rates & so far working out great for me.

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