Forbes.com recently published an article that will appear in the June 30, 2014 issue of Forbes magazine, “How Much Will You Earn On Your Stocks and Bonds?”. The author’s basic contention is something we have all heard many times, which is that investors tend to invest in asset classes that have recently outperformed and vice versa. The author states his case succinctly: “The pattern: If an asset class has done well recently, making its price high, fund buyers want it. If it has done poorly, making it a bargain, they want to sell.”
To buttress his argument, the author refers to the work of Robin Greenwood and Andrei Shleifer, authors of a National Bureau of Economic Research (NBER) working paper, “Expectations of Returns and Expected Returns.” In that paper, the main findings were that investor expectations of stock returns are:
• highly correlated across data sources
• positively correlated with flows into equity mutual funds
• highly extrapolative
• negatively correlated with model-based expected returns
• weakly negatively predict the stock market
The NBER paper goes a long way toward adding more of an empirical view to what most of us already take to be gospel.
An excellent book on this same subject is, Mean Markets and Lizard Brains: How to Profit From the New Science of Irrationality. In this book, author Terry Burnham makes the case that, as an evolutionary adaptation, “we are built with a backward-looking, pattern-seeking brain that tends to make us want to buy when prices are irrationally high and sell when prices are irrationally low.”
What’s interesting in the Forbes article is the contrast that the author creates by comparing the return differences between “dumb money” and “smart money.” Dumb money (in the case of stocks) is the last five years of total annualized return, less inflation. By taking the historical stock market return of 6.6% and making some adjustments based on the how much price/earnings have expanded (and, thus, are expected to revert to the mean) over the last century, the author arrived at a “smart money” projected return. A similar process is applied to other asset classes: junk bonds, 10-year Treasuries and a “hot stock fund.” The differences are quite dramatic:
Stocks
Dumb money: 18%
Smart money: 5%
Junk Bonds
Dumb money: 11.9%
Smart money: 0.7%
10-Year Treasury
Dumb money: 5.7%
Smart money: 0.6%
Hot Stock Fund
Dumb money: 24.3%
Smart money: 4.7%
The method that the Forbes author used to create these numbers may be off base. In fact, you would have to read the entire article and determine for yourself if the assumptions the author makes seem reasonable, especially as it relates to the “smart money” projections. At the very least, one can say that most investors probably do not believe that the last five years are going to be as good as the next five years. Consequently, the term “dumb money” probably does not match up perfectly with investors’ expectations.
There is, however, little doubt (based on studies such as that which was conducted by the NBER) that investors' expectations generally are negatively correlated with what will actually happen. No matter how many times you say it — “past performance is not a predictor of future performance” — it just does not sink in. And the challenge goes deeper than simply being an educational issue in that we have been hard-wired through many eons of evolution to be backward-looking, pattern-seeking creatures.
Conclusion
What is a plan advisor to do? Be a bearer of bad news? Suggest defensive strategies to deal with a possible sudden reversion to the mean? Emphasize the need to increase contributions to meet future goals? Focus on plan design structures that help raise the level of contributions. All of the above?
The fact is that, for some time to come, there just may be too much money chasing too little investments. Cheap money results in low fixed income returns, which, in turn, tend to create “asset inflation,” especially as it relates to equities. We may simply be at the point where a combination of global deleveraging, over-supply and other deflation forces will result in the markets being somewhat anemic for some years to come.
In the coming years, accumulators may see their nest eggs being primarily fueled by their contributions with meager returns. De-accumulators will have to work hard to create an income stream that exceeds inflation.
What is certain is that investors — plan sponsors and participants alike — will require professional guidance, now more than ever, to help navigate these mostly uncharted waters.
