Learning to avoid overconfidence, unnecessary fear

Allen Wisniewski

When it comes to investing people frequently fall into one of two categories. Some have expectations that are clearly excessive, while others are too pessimistic. Oftentimes the same person can exhibit both of these traits depending upon how the market is doing at a certain point in time.

What people first need to have is some reasonable expectation of market returns and variability. There are some who think a typical stock market return is 15 to 20 percent on an annual basis. Others think it is 0, in that the market goes up, as much as it goes down.

If you look at long-term historical figures going back to the 1920s the stock market has averaged returns of about 10 percent per year. Future returns will likely be somewhat lower, possibly 7 to 8 percent per year.

There are several reasons why future returns will be lower. The most significant is that the economy or GDP is growing slower. Corporate profit growth is highly correlated to the overall growth of the economy. In addition profits, as a percent of sales, are near record levels, which implies profit margins are not likely to expand much more.

We are currently in a low inflation environment. Even if future returns are only 7 percent per year, if inflation is 2 percent, someone is still netting 5v on an annual basis. The historical returns of 10 percent per year included an average annual inflation rate of 3 percent, for a real return of 7 percent per annum.

If people could count on consistent stock market returns every year, whether it be 7 percent or 10 percent, investing would be quite easy. However, most investors realize stock market returns are highly variable. Most years, stock market returns range from -10 percent to 25 percent, though on occasion they can be significantly better or worse. For example in 2008 the S&P 500 index had a total return of -37 percent.

There are knowledgeable investors who understand the historical returns and variability of the stock market. However, some of these investors may be too confident in their abilities. They might think, all I have to do is be out of the market during the bad times and be invested during the good years. However, most investors who try to time the market wind up doing worse than the long-term averages.

Some investors might gravitate towards bonds understanding they are less risky than stocks, and historical returns have been decent. With bonds the biggest determinant of risk is the length of their maturity. When interest rates are changing significantly returns from longer term bonds will be much more variable than shorter term ones.

Many bond funds may show historical annual returns in the last 10 to 20 years in the 5 to 7 percent range. However, that would be an unreasonable expectation for future returns. That is because interest rates today are significantly lower than they were in the past. A reasonable expectation for future returns for someone invested with intermediate term bonds might be 2 to 3 percent per year.

For someone who is a more fearful investor, bonds may not be as good of an alternative to stocks, as they have been in the past. This is not to say that a cautious person should be primarily invested in stocks. However, the conservative investor should be aware of the risk with longerterm bonds. That individual should have a balanced portfolio with stocks and intermediate term bonds.

The confident investor needs to be careful not to have an overly aggressive portfolio. That person needs to realize that investing in mutual funds that have had the best one year performance frequently do poorly in market corrections because of the risk they are taking.

Both the confident and fearful investor need to be careful not to let short term market movements influence their decision making. If someone altered their long-term investment strategy due to the recent market volatility then they need to examine how they make their investment changes.

Investors do need to make periodic changes in their portfolio. Sometimes someone’s circumstances may have changed, or their mix of assets has deviated from their target range. However, other adjustments should be based on reasonable expectations of future returns and risk, not because of fear or greed.

Allen Wisniewski has been involved in finance for more than two decades. He lives in Culver City with his family.