Why equity investors’ returns are less than they could be – and the strategy that’ll improve them
According to Credit Suisse, equity investors earn, on average, returns that are well below those of the index.
As part of the bank's Global Investment Returns Yearbook, analyst Michael Mauboussin says the answer as to why lies in a behavioural bias which can be traced to the part of our brain that links cause and effect.
Source: Credit Suisse
Equity traders have a tendency, he explains, to buy after the market has risen and to sell after it’s declined, driving asset-weighted returns below time-weighted ones. Our minds can encourage us to act in extremes, buying when the market’s doing well and selling when it’s down.
By way of explanation – and solution – Mauboussin points to a 1973 paper, “On the Psychology of Prediction”, by Daniel Kahneman and Amos Tversky. The psychologists emphasise three types of relevant information when it comes to sidestepping this kind of behaviour.
First, looking at the base rate. In terms of the stock market, this would mean the historical record of returns – thinking long-term, rather than extrapolating recent results.
Source: Credit Suisse
Here, r is very close to zero. Practically, that means the best prediction of next year’s return rate is roughly consistent with the base rate, explains Mauboussin.
Second, taking into account specific information about the particular case you’re looking at. For markets, that means some sense of valuation and what that implies for future returns.
And last, examining how to weight the base rate and the specific information at hand in order to make a sensible prediction.
Kahneman reckons we tend to underweight the base rate in many of our predictions. When dealing with an activity where luck’s the main factor, he suggests placing almost all the weight on the base rate. But then if luck plays a minor role, almost all the weight should be placed on specific information.
So, in cases where the correlation coefficient if close to zero – as it is for equity market returns – a prediction that relies most heavily on the base rate will probably outperform predictions that come from other approaches.
In short, investors shouldn’t get too caught up in short-term results – an asset allocation strategy that takes a long view is going to do better.
Credit Suisse explains the lesson:
Since year-to-year results for the stock market are very difficult to predict, investors should not be lured by last year’s good results any more than they should be repelled by poor outcomes.
It’s better to focus on the long-term averages and avoid being too swayed by recent outcomes.
Avoiding the dumb money effect boils down to maintaining consistent exposure.