The Biggest Risk Facing Investors

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Expert Analysis and Commentary

The Biggest Risk Facing Investors

Larry Swedroe Mar 30, 2015

One of the questions I’m most asked during media interviews is, “What are the biggest risks facing investors?” My usual response is that the greatest risk for most investors is staring at them right in the mirror. As legendary comic strip character Pogo said: “We have met the enemy and he is us.”

Investor Mistakes

My book, Investment Mistakes Even Smart Investors Make and How to Avoid Them, covers 77 errors frequently committed by investors, many of which are behavioral in nature. Below is a list of the 10 biggest, and most common, behavioral mistakes or biases investors are prone to making:
  • Overconfidence: An investor’s overconfidence in his ability can lead to excessive risk taking, inefficient diversification, excessive trading, and making the mistake of treating the unlikely as impossible and the likely as certain.
  • Recency: Recency is the tendency to overweight recent events and/or trends and ignore the long-term evidence (which can then lead to overconfidence). This bias often results in investors buying assets after periods of strong performance (high) and selling after periods of poor performance (low). Such behavior is the opposite of what an investor should be doing (rebalancing) to maintain the portfolio’s asset allocation.
  • Hindsight bias: Hindsight bias is the belief that events are more predictable after the fact than before, leading to overconfidence and excessive risk-taking.
  • Herding: A lack of individual decision-making or thoughtfulness can lead investors to “herd,” or make investment choices based on their observation that many others are investing in the same manner. The fear of missing out on a good investment is often a driving force behind herding. This can result in excessive risk-taking (and bubbles) in bull markets and panicked selling in bear markets. Herding also reduces the potential for feeling regret if your investments underperform those of your peers.
  • Anchoring: Anchoring describes the tendency to rely too heavily on the first piece of information (such as the price paid for a stock) offered when making decisions. This can cause an investor to hold on to losing investments while waiting for the investment to break even, anchoring the value of their investment to the value it once had.
  • Confusing familiarity with safety: This mistake can lead to a home-country bias, inefficient diversification and overconfidence. It also often results in a failure to consider the risks associated with an investor’s labor capital, leading to overinvestment in the stock of one’s employer.
  • Playing with the house’s money: It’s not the house’s money. It’s yours. Thinking about this the wrong way can lead to excessive risk taking when investing with profits.
  • Regret avoidance: The pain of admitting a “mistake” leads investors to not correct bad decisions, which often makes those decisions worse. Regret avoidance is the result of cognitive dissonance. It leads to the sunk-cost bias, which is the tendency to avoid recognizing losses despite the fact that the loss has already occurred. For taxable investors, regret avoidance leads to the loss of the tax benefits available from harvesting losses.
  • Self-attribution bias: Self-attribution bias can lead to taking credit for successes and blaming others or bad luck for losses. This mistake can result in overconfidence in one’s ability to predict the future.
  • Confirmation bias: This is the tendency to give more weight to the evidence that confirms our beliefs, regardless of whether the information is true or not, than to evidence that contradicts them. As a result, we tend to gather evidence and recall information from memory selectively, and we interpret it in a biased way. What’s more, confirmation bias can lead to additional investing mistakes because of what is called groupthink—the disproportionate exposure to support for our beliefs.

Overestimating Future Returns

From 1926 through 2014, the S&P 500 Index returned 10.1 percent annualized and the five-year Treasury note returned 5.3 percent. A typical 60 percent stock and 40 percent bond portfolio, rebalanced annually, would have returned 8.7 percent over this period on a nominal basis and 5.7 percent in terms of real returns. Given the historical evidence, an investor might then build his retirement plan based on these returns. The problem is that expected returns are now much lower.

To begin with, today’s bond yields are now way below the historical return of 5.3 percent. Thus, an investor should in no way assume a return of 5.3 percent going forward. As I write this, the current yield on the five-year Treasury is just 1.3 percent.

When it comes to forecasting equity returns, the best tool we have is the adjusted Shiller CAPE 10 ratio. This ratio is currently at about 26.5, providing an earnings yield of about 3.8 percent. We need to adjust that figure to consider the fact that the Shiller CAPE 10 is lagging earnings by an average of five years. If we then assume an approximately 2 percent growth in real earnings, we can multiply 3.8 percent by 1.1 [1 + (0.02X5)] to get an earnings yield of about 4.2 percent. That gives us the expected real return on stocks.

We also need to add in expected inflation to get the nominal expected return. The current consensus forecast from the Philadelphia Federal Reserve’s most recent survey of professional economists is for inflation of 2.2 percent over the next 10 years. That leaves us with a nominal return estimate of 6.4 percent for stocks.

Clearly, today’s 60/40 portfolio cannot be expected to earn anywhere near the historical return of 8.7 percent. The weighted average of the current five-year Treasury yield (1.3 percent) and the adjusted CAPE 10 earnings yield (6.4 percent) leaves us with an expected return of 4.3 percent in nominal terms and just 2.1 percent in real terms. And both are well below the historical average. Even if you assume that the current regime of zero-to-negative real bond yields won’t last much longer, expected returns are now much lower than the historical levels.

While we cannot know the future, investors might get lucky and earn a higher return than the evidence indicates they should expect. But building an investment plan based on luck isn’t an intelligent strategy. Investors with financial plans that depend on earning the historical rate of return, instead of today’s best estimate of future returns, are likely to not have sufficient assets to sustain their planned spending. And living without sufficient assets to support the planned-for lifestyle isn’t an outcome most people would even care to contemplate. Even worse is running out of money. That’s virtually unthinkable for most people.

The Bottom Line

The bottom line is that it’s important to make sure your plan is based on the best estimates of future returns. And simply using historical returns isn’t a good methodology because current valuations and yields matter.

It’s also important to note that what holds for individuals also often holds for state and local, as well as corporate, pension plans. Many have adopted return assumptions that are either optimistic or, even worse, wildly optimistic. The result will likely be that future taxpayers will have to foot the bill for underfunding, pensioners will not get the benefits they are counting on, or some combination of both.

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