Expectations and perception
Ask someone what sort of returns they expect to see in the stock market. My guess is you will get answers ranging from “I would never invest in stocks as they are too risky” to “about 3%” to “I think I can get 20%” to “I doubled my money last year on company XYZ.”
While it is possible that all of these might be right at some point, the reality is that a very large part of the investment experience is driven by expectations and perspectives. In this blog post, I’m going to do two things:
- First, I’m going to share some data about the historical performance of the equities markets. While there is no guarantee that the future will look like the past, the past is our best predictor. By reviewing what has happened in the equities markets, hopefully anyone reading this will have a better reference point for expectations.
- Second, I’m going to share some thoughts on how to frame your perceptions based on the ACTUAL performance of equities going forward. It is critical that, as you go through your “lifecycle as an investor,” you are constantly aware of your emotions and monitor/manage them so that your perceptions are more closely aligned with the experience.
Let’s start with expectations. Historically, there are three things that have proven to be true about equities:
- Equities have higher expected returns than safer investments like Treasury bills.
- Equities don’t all have the same expected return.
- Expected premiums are positive but not guaranteed.
These “truisms” have been shown empirically to be true (see the attached article) and also make sense from a “sniff test” standpoint.
Going through them one at a time:
- We would expect equities to have higher returns than government or other fixed income securities. Fixed income securities are higher in the debt structure and are essentially “LOANS” to a business. Equities are OWNERSHIP. When you own a business there is definitely risk; as a result, owners are compensated with a premium on their returns.
- Some equities have historically outperformed others:
- Small stocks perform better than big companies. This makes sense as very large companies (e.g., Apple with a $1 trillion-dollar market cap) simply cannot grow at a high rate forever— the mathematics would have them taking over all of the world’s capital (and no I do NOT want to hear from any conspiracy theorists about Apple’s grand plan)!
- Value companies outperform growth companies. Again, no surprise. When everyone is jumping on the “next big thing” bandwagon, they drive pricing up. Over the long term, these expectations cannot be met; as a result, we see a “value premium” in equity markets across time and geography.
- Finally, profitable companies outperform unprofitable companies in terms of equity returns. I cannot think of a more obvious thing to expect, and I am not shocked at all about this premium in the equities market.
- While the premiums HAVE emerged over time, and the expectation is that the WILL continue to be present over time, they will NOT occur each and every year. In fact, there may be some extended periods of time where the aforementioned premiums are absent. That does NOT mean they are not present. It simply means that other factors are currently having a bigger influence on returns.
The key is to remember that stocks outperform bonds, small outperforms big, value outperforms growth, profitable outperforms unprofitable, and nothing is guaranteed to ALWAYS occur. These are, in my opinion, the foundations that all investors should build their expectations upon.
While expectations are critical, our emotions are such that all of the rational, logical data in the world will not keep us from feeling uncomfortable at certain times. This is because our perceptions are out of alignment with what is currently happening.
The best example of this is in regard to the response that people have to bear markets. I can show you all of the data in the world that suggests certain collections equities have historically seen up to a 50% LOSS in a 12-month period, but have ALWAYS seen positive returns over a ten-year period in time. However, when you see your portfolio decline by 50% in value you will have the PERCEPTION that the world is ending, and likely you will feel extremely uncomfortable, nervous, and worried. Almost everyone I know who has been investing for more than a decade has experienced these emotions. They are NORMAL.
The key is to set our EXPECTATIONS NOW that our PERCEPTIONS are going to be distorted in the future. While this likely will NOT make us feel any better in the eventual moment, it WILL help to keep us from making foolish decisions when we experience market corrections or bear markets.
Keeping your emotions in check by understanding that your perceptions are NOT consistent with expectations is one of the cornerstones of investment success. The attached article goes into more details on the importance of expectations and perspective.
- Do you have a well-defined Investment Policy Strategy that is used to drive your investments in support of a comprehensive financial plan?
- If not, would you like to partner with someone who is used to helping people get through these struggles and (then, with confidence) implement portfolio strategies in a systematic manner while focusing on your desired outcomes?
If so, feel free to send us an email or give us a call. We’d love to have the opportunity to help you find a bit more peace of mind when it comes to investing.
Enjoy the read and remember, it’s NOT about the money. It’s about how the money supports your goals!
Photo credit: Nick Karvounis on unsplash.com
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