Delusions of Future Outperformance

“The market is not a very accommodating machine; it won’t provide high returns just because you need them.” – Peter Bernstein

As I’ve been discussing over the past year or so (see here, here, here, here and here), there have been a number of high profile predictions made for lower than average returns in the financial markets over the coming decade because of low interest rates on bonds and above average valuations on stocks.

The arguments are compelling and I like to err on the side of conservatism when setting performance expectations, so I think it makes sense for investors to pay attention to some of these claims. But the funny part it that rarely, if ever, will you hear a portfolio manager or investor claim that they themselves will experience lower than average returns.

The common refrain goes something like this: Have fun earning paltry market returns from these levels. To which my response would be: Where exactly do these people think their returns will come from? It’s not like it all the sudden becomes easier to beat the market if we do in fact see a lower return environment. Everyone is fishing in the same pond.

Here are some of the rebuttals you’ll often hear from those who think they’ll be immune from the possibility of below average market returns:

  • I’ll just pick the best stocks.
  • I’ll be able to nail the market’s reaction to the ongoing Greek crisis.
  • I’ll be able to jump in and out of bonds and call the next big move in the interest rate cycle.
  • I’ll just short the market before it starts to fall during the next bear market.
  • I’ll go to cash before things really get out of hand.
  • I’ll just pick top quartile funds.
  • I’ll just listen to my favorite hedge fund manager who will surely tell me when to get out of the market.
  • I’ll just be fearful when others are greedy.
  • I’ll just use leverage to juice my returns.
  • I’ll be much better at choosing securities when things get rough than I have been during this bull market.
  • I’ll be able to rotate into the best performing sectors ahead of time.
  • I’ll be able to follow my foolproof system that crushed the market in my elaborate back-test.
  • I’ll be able to pick the top performing asset classes in advance.
  • I’ll see the next recession coming.
  • I’ll change my style for whatever the market environment calls for.

I’m not delusional. Some investors will be able to thread the needle and pull it off. But there are also a large number of investors who are delusional, because they’re making the assumption that they’ll be the ones who can pull it off, when in fact only a very small number of people can. There’s a seemingly endless supply of investors out there who try again and again to outsmart the markets, but only end up outsmarting themselves.

The only reason certain investment strategies succeed over time is because so many investors try and fail at this laundry list of hopeful tactics. But this is a good thing because it’s part of what makes the markets function. It’s unfortunate some investors won’t do as well as others, but there are always going to be investors who will benefit from the mistakes of others.

In the seemingly never-ending debate on the efficient market hypothesis, many point to the fact that so few investors are able to beat the market over the long-term as proof of the market’s efficiency. I look at these stats from a completely different angle. I view the fact that there are so many investors out there who assume that they will be one of the few who will beat the market over the long-term as a sign of how inefficient human nature can be. If markets were truly efficient, not nearly as many investors would try to outperform.

I’m not saying there are no good active managers out there. That’s just not true. I know for a fact that there are active managers who can and will beat the markets. What I am saying is that there are far more investors out there who believe that they can and will beat the market, when the weight of the historical evidence, and the simple zero sum nature of the markets, tells us otherwise.

A number of investors have been proclaiming that they can’t wait for this Fed-induced bull market to end so they can finally utilize their investing prowess to destroy the market. Some strategies are geared towards protecting capital on the downside, so for some this will be true. It’s good to have confidence in your process, but many of these people have delusional expectations about their own investing abilities. Investors hoping for a low returning market to prove themselves should be careful what they wish for. There is no such thing as an easy market to invest in.

Further Reading:
Expectations Management
The Value of I Don’t Know

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Discussions found on the web
  1. Scott Boone commented on Jun 29

    “Everyone is fishing in the same pond” Truer words were never spoken, yet over the course of a 40+ year investment career, I seldom met a client who didn’t believe that we somehow had access to a private pond, stocked with much bigger fish! Partly this was based on the belief that because they were paying us a goodly fee, we would somehow earn this fee with outsized returns, and partly through an enduring belief in magic – that there was, in fact, some secret or trick to investing that their fees could purchase. Even when faced with the cold hard facts that they had a spending problem, rather than an income problem, few clients could be convinced that we couldn’t somehow simply adjust their returns upwards and solve their financial woes.

    • Ben commented on Jun 29

      That could be one of the hardest points to get across to the majority of clients. That perspective is not an easy one to accept because we all want to believe that either (a) we’re exceptional or (b) we can easily spot other exceptional people. It’s amazing how freeing it can become once you let go of that mentality.

      • acm_acm commented on Jun 30

        I have a stable of multi-employer pension fund trustees that need to hear this. They all think they’re going to get 8% going forward from today with a 60/40 asset allocation.

        • Ben commented on Jun 30

          Ha. Better not break it to them. They’re not going to want to hear that their assumptions are wildly optimistic with interest rates at 2%.

          • FinancialDave commented on Jul 02

            Just do what most do and only show them the returns from the last 5 years that should hold things up for awhile.

          • Ben commented on Jul 02

            That’s true. Once those 2008 numbers dropped off, funds were much quicker to present their return numbers to investors. As always, context matters.

  2. Smart Money MD commented on Jul 02

    Always good to have a reminder of this. The recent downturn of my index funds have gotten me to wonder whether I can time my trades. Then I remind myself that I’m not different from any of the millions who’ve tried to time the market and not succeed!