Stock Investors Overstate Their Gains in the Heat of Bull Markets
Most investors know the average long-term return for stocks. It is 6.5 percent real. That’s of course a very good return. That’s a high enough return to permit most middle-class people to finance a decent retirement by the time they turn 65. We should be happy with it.
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Q2 2021 hedge fund letters, conferences and more
Mohnish Pabrai Q&A: Investing Like An Owner And Mistakes
In May, the value investor Mohnish Pabrai took part in a Q&A session with London Business School MBA students, who quizzed the investor on many different topics, including his experience running his own business in the 1990s. Q2 2021 hedge fund letters, conferences and more Owning A Business And Being An Investor Pabrai told his Read More
We are not.
Practicing Market Timing
If we were happy with it, we would all practice market timing. When returns got much higher than that for a number of years in a row, we would understand that the extra returns were not real but just the product of irrational exuberance and we would not count on those gains in the same manner as we treated the gains that were the product of economic growth. But of course most of us follow Buy-and-Hold strategies. We treat all gains as equally real and we disdain market timing.
That means that most of us don’t really earn that average 6.5 percent real return. We buy more stocks when prices are high and long-term returns are low because stocks possess more emotional appeal at such times. Instead of buying more stocks when prices are good (that would be timing!), we buy more stocks when prices are bad and thereby pull our personal return below the average return. If there’s a benefit to practicing price discipline (there must be!), there’s clearly also a detriment to failing to practice price discipline.
The benefits of price discipline are so easy to understand that it can be hard to comprehend how we manage to deceive ourselves re the need to engage in market timing. But it clearly is possible to do this. It’s been going on since the first stock market opened for business.
The trick is to keep focused on the present moment and to avoid thinking too much about how stocks have always performed in the long term. One tactic that we employ is to overstate our gains in the heat of bull markets. If you listen to other investors (and we all do — there is something deep in human nature that causes us to want to turn to our fellow humans to provide reassurance and to help us figure things out), you will hear lots of reports about how stocks are an amazing asset class at just the times when they are most dangerous.
The Buy-and-Hold Advice
The standard Buy-and-Hold advice is that the typical investor should go with an allocation of 60 percent stocks, 30 percent bonds and 10 percent Treasuries. I advocate that investors increase their stock allocation to 90 percent at times of super low valuations and decrease it to 30 percent at times of super high valuations. That suggestion is often met with shock. It cannot possibly be right, can it? Everyone knows that market timing is a bad idea, don’t they?
Something that has often puzzled me is that it is common at times of high stock prices for Buy-and-Holders to go with stock allocation percentages of much more than 60 percent. There’s a fellow who posted at a discussion board that I used to frequent (in the days before I was banned from it) who published a study showing that an 89 percent stock allocation is “optimal.” His allocation recommendation was 30 percentage points above the conventional recommendation just as mine was 30 percentage points below the conventional recommendation. But his recommendation was never met with shock. He was generally viewed as being brave enough to be a bit smarter about stock investing than what the conventional advice called for.
Investors measure success in the short term. A 90 percent stock allocation obviously produces bigger gains than a 30 percent stock allocation during a bull market for the same reason that a 30 percent stock allocation produces bigger gains than a 90 percent stock allocation in the long term for stocks purchased at bull-market prices. It is short-term results that make the bigger impression on the vast majority of investors. It’s only researchers who go to the time and trouble to see what works in the long term and the research projects that show the dangers of buying stocks during bull markets don’t tend to go viral at the times when the message they communicate most needs to be heard.
Investors Have Stock Investing Figured Out
Investors who obtain good results brag. It is human nature. Most investors who go with a large stock allocation are worried about doing so at the time they make the choice. So they are relieved when their bet seems to have paid off. And they tell everyone who will listen that they have this stock investing thing figured out. When the losses come, as they inevitably do, they keep it to themselves. Stock gains are reported far more frequently than stock losses.
Which causes us all to form a confused understanding of the realities of stock investing. Most of us go by what we hear from our friends and neighbors and co-workers. They almost always overstate their gains and understate their losses. So we come to believe that stock investing is less dangerous than it in fact is. And our lack of appreciation of the very real risks associated with this asset class cause us to invest in such a way as to earn lower returns than the 6.5 percent real long-term average return suggests should be easily available to us.
That 6.5 percent return is an average. Investors who practice price discipline/market timing beat the average by investing more heavily in stocks at the times when their going-forward return is likely to be higher. It follows that investors who follow Buy-and-Hold strategies obtain long-term returns lower than the average return. We all need to work to tune out what we hear from other investors and from the experts in the field and to focus on what the peer-reviewed research has to teach us about these matters.
Rob’s bio is here.