One of my most recent posts was on how forecasting is so difficult, if not impossible. It's amazing, even though we know it is impossible to forecast the future, we are still willing to listen to those willing to tell us what is going to happen. Nowhere is this more true than in the financial markets. We cling to their prognostications with the hope that they will enlighten our futures.
I believe that part of this desire to know the unknowable future is simply part of our evolution. You see, one of mankind's most extraordinary talents is mental time travel, the ability to move back and forth through time and space in one's mind. We may take this ability for granted, but being able to envision a different time and place has been critical to our survival. This mental time travel allows us to plan ahead, to save food, and to endure hard work for a future return.
However, this conscious foresight came with a price...the knowledge that somewhere in the future death awaits. Most biologists agree that this awareness of our own mortality would have stopped human evolution in its tracks, unless something else intervened. If humans obsessed about their impending demise, they would have stopped gathering food and working towards the next day. What intervened was irrational optimism.
Humans are irrationally optimistic, we habitually expect things to turn out better than they actually will. Neuroscientists and social scientists agree that we are much more optimistic than realistic. We hugely underestimate our odds of getting divorced, of losing our jobs, or of getting cancer. While we overestimate the odds that our children are gifted, that they'll do better than their peers, or how long we'll live. This optimism bias is present in every race, religion, age group, and socioeconomic bracket.
You'd think that this optimism would erode under the constant tide of bad news; wars, high unemployment, political strife, terror, and the Pittsburgh Pirates. This is true to a point. Collectively we can grow pessimistic, but our private optimism, about our own future, remains incredibly resilient.
This wonderful irrational optimism has driven the human race to constantly move forward, to believe that they can overcome obstacles, and make the world a better place for future generations. Without optimism our ancestors might never have ventured out of their caves. But optimism can also lead us into making some pretty dumb decisions; not going to the doctor, not saving enough, or playing the lottery.
When it comes to investing, our optimism bias and our selective memory, can get us into a world of hurt. As humans we have a strong tendency to believe that our specific investments will do well, especially when compared to those of the overall market. We tend to extrapolate past successes into the future, and we tend to forget about prior failures. In other words we overestimate the odds of positive outcomes, and underestimate the odds of negative outcomes.
How can we overcome these evolutionary biases? Mathematics, and a willingness to expect the unexpected.
Mathematics, and more specifically an understanding of probabilities, can help many investors focus on "realistic" expectations vs. "optimistic" expectations. Over the last thirty years US Treasury bonds have been excellent investments, returning 9.2% per year. While this was fabulous, it was also what you should expect when interest rates fall from 12% to 2%. Realistic expectations for returns on US Treasuries today should be around 2%, with the added risk that they may be much lower (inflation adjusted). Jim Grant said it best, "US Treasuries have evolved from risk-free return to return-free risk!"
The same holds true for US Stocks, which provided investors with a mouth watering 9.9% annual return over the last thirty years. Now of course stocks were extremely cheap back in 1980, yielding 5.14% with a P/E (price-to-earnings) ratio 7.4x. Today stocks have a current dividend yield of 1.9%, and a P/E ratio of 14x, a more rational expectation for equity returns going forward is about 5%.
While our irrationally optimistic mind might expect future investment returns in the mid to high single digits, our rational mind says low single digits is more probable.
Our other safeguard from irrational optimism is a willingness to expect the unexpected. Just because it hasn't happened in our lifetimes doesn't mean it won't. One quote that constantly plays over and over again in my mind is, "The failure rate of all great civilizations is 100%".
Global Tactical Asset Allocation is the only investment strategy that I know of that systematically helps us overcome our optimism bias. By focusing our investments into those assets that are working, as opposed to those that we hope would work, we are in harmony with reality. And more importantly, by being willing to allocate significant assets to cash when things simply aren't working out as expected.
Keeping our irrational optimism in check is our specialty. The future may be bright, but we'll keep our shades handy.
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