In this time of slumping equity markets, many Americans need to learn some simple lessons about investing. Perhaps the most important lesson is not to get trapped by unrealistic expectations. And it is unrealistic for any individual to expect equity market returns to consistently beat market averages. But many benighted individuals are still confident that they can.
Take the subject of a story in a local newspaper. A 62-year-old business consultant was described as having lost about half the value of his portfolio in recent months and reportedly has sought outside investment advice. “He said he’ll be content if he can earn 10 to 15 percent a year,” the article reports.
This good man’s criteria for contentment are likely to leave him unhappy. He would be better off to be satisfied with the average returns chalked up by broad market indexes such as the S&P 500 or Russell 3000. He would probably save himself money by putting his funds into an index mutual fund and forgetting about paying fees or commissions to his new financial adviser. And so would most individual investors.
I think it is fair to say that most economists would agree with this advice. But it runs counter to the general public’s perception of the discipline.
Many people assume that economists have some special insight into what the future holds for interest rates and stock markets. They query us for tips on what shares to buy or whether they should lock in a mortgage interest rate.
What they don’t realize is that most scholarly economists — as opposed to the Wall Street gurus pitching views that favor their particular employer — believe that markets are “efficient” and that no individual can forecast market moves and consistently “beat the market” over the long term.
Markets are efficient in the sense that they digest all available information about a stock, bond or exchange rate and that the resulting market price is the best estimate of the value of the asset based on information then available and rational expectations for the future.
But circumstances change every minute and these changes are essentially random and unpredictable. No one knows what the future will bring and how that will affect individual firms or even sectors or nations.
Those rare few are random outcomes counterbalanced by those who do worse than the average. Yes, George Soros made billions in exchange-rate speculation and Warren Buffett has grown fabulously wealthy picking stocks. Famous mutual fund managers such as John Bogle and Peter Lynch beat market averages for years. But to most economists, these individual successes are anomalies that can be expected in a statistical sense.
Many people buy advisory newsletters that rate mutual fund performance. They look for the funds that have shown the best performance and buy them. But the old law of “reversion to the mean” kicks in. Past performance truly is not a guide to how funds will do in the future.
Simulations of what would happen if someone consistently transferred money into the best funds in such newsletters consistently show no better outcome than the market average. The same goes for individual stocks.
If most economists believe that stock picking is a futile exercise, why do thousands of financial advisers continue to earn a living and why do Americans spend tens of millions of dollars on books and lectures instructing them how they can be successful?
The answer is that hope springs eternal in the human breast. And Americans prefer activity to being passive. Managing an investment portfolio gives people a sense of control over their future. It is a consumption activity that produces satisfaction in itself.
Economists have tried to convince the general public of the benefits of trade for 226 years, and we have not succeeded yet.
Given human nature, it is not likely that we will do any better convincing people to be content with average market performance. But don’t say we didn’t warn you!
© 2002 Edward Lotterman
Chanarambie Consulting, Inc.