Investing is an exercise in optimism. Every time we purchase an asset, we express confidence in the future: that companies will grow their profits, borrowers will repay their debts and governments will allow capital to move freely around the world. Without optimism, there could be no capital markets, no entrepreneurship and ultimately no human development. Too much optimism can be dangerous for investors, however, as it can alter our behaviour leading us to take too much risk.
In a survey of 8,550 investors across 24 countries, asset manager Natixis recently found that, on average, investors expected an annualised long-term return from equities of 14.5% above inflation. If we assume long-term inflation is 2%, this equates to an annualised nominal return of 16.5% – or 360% over a 10-year period.
While such a return is not impossible, according to S&P 500 data from 1871 to today, a 10-year real return of this magnitude has only occurred 7.35% of the time. Even more strikingly, this probability falls to just 0.36% – that is, a 1 in 277 chance – when the starting point is at an all-time high. This unusual level of optimism among such a large and diverse sample of investors can provide us with some important lessons, especially in the context of the last year and the returns ahead of us.
‘Base rate neglect’
The first is that, when thinking about returns, investors tend to suffer from ‘base rate neglect’. This is a well-documented phenomenon of ignoring long-term data – the base rate – when making forecasts, in favour of a more recent experience or an appealing narrative. It is a matter of focus, where we tend to channel our thoughts to what we perceive to be the most relevant information only, often to our own detriment.
In behavioural science, this is an area Amos Tversky and Daniel Kahneman famously explored as the “Linda problem”, which confuses us as the probabilities of success change depending on how much information is added. The probability of a sporty person being an accountant, for example, is mathematically higher (say 3% of the population) than the probability of them being an accountant and also going to the gym three times a week (say 1% of the population). We naturally screen only what we think is relevant, even if the probability of success deteriorates.
Let’s turn this logic back to investment markets. In contrast to the expectations of the Natixis survey respondents, a reasonable base rate expectation for equity returns is around 7.5%, if the empirical evidence is our guide. This leaves an enormous gap of around 7% between current expectations and historical norms.
Recent experience
One of the reasons expectations have strayed so far from a reasonable expectation is that investors tend to be conditioned by recent experience. The expectations stated by investors are similar to those received over the last three years – 15.2% real returns per year – despite the fact we are starting from a very different position.
While it may be reasonable to increase return expectations as the economic conditions become more supportive, it is essential to consider the expectations that are already discounted in the share price of companies as, if they are to be sustainable, all gains in the price of an asset must ultimately be reflected by the underlying earning power of that business. This is what Howards Marks eloquently describes as ‘second-level thinking’.
It is for this reason that a valuation anchor is so important. While it has become fashionable to dismiss traditional valuation metrics – and reasonable to debate the relevance of asset-based valuation models in an environment where asset-light businesses can generate both high growth and high returns with little capital – it is also worth remembering a reasonable valuation of an asset is the only defence we have against excess optimism (or pessimism).
Few ‘bargains’ available
That is why our investment management team runs valuation models on more than 350 groups of assets each month to identify the most attractive options. As prices have risen over the last year, these models indicate there are very few ‘bargains’ available for investors that would lead us to expect returns above the base rate. More likely future returns from some markets, such as US equities, may be well below the base rate, given the lofty valuations.
In today’s context, the danger for investors is twofold. First, they will save too little as they expect their invested capital to make an unrealistically large contribution to meeting their financial goals. Second – and perhaps more dangerous to their long-term goals – is the failure to achieve the expected, but unrealistic, returns may discourage them from making additional investments or may even lead to them selling those they already have and, in doing so, destroy the benefit of long-term compound returns that lies at the heart of every successful investment strategy.
To overcome this, we need to ensure investors have realistic return expectations, not only at the beginning of the investment journey but every time we engage with them. By reminding investors that returns are likely to revert to a long-term base rate, we can help quell the optimism that emerges during periods of high returns and combat the pessimism that accompanies bear markets. If we do this well, we can all be optimistic about the future of our investors.
Dan Kemp is global chief investment officer at Morningstar Investment Management
