I try to avoid engaging in the folly of making predictions about financial markets, but here is one. Returns over the next decade from most asset classes will be significantly lower than they have been in the past decade.
It doesn’t take a soothsayer to foresee this. Valuations in many areas are stretched and the expected return from a traditional 60/40 approach is close to historic lows. Of course, this forecast could be wrong; there are scenarios where returns run even hotter from here, but that should be considered a low probability path.
What’s puzzling about the current backdrop is not that it is one defined by low expected returns – markets are cyclical and these environments will occur – but the investor response to it. We might anticipate a rational reaction to be an increased interest in out of favour areas with more appealing valuations, but that’s not what happens. Instead, we keep buying the most expensive assets. When confronted with lower expected returns we buy more of the asset classes and funds that are likely to have the lowest future returns.
Rather than consider this activity to be incongruous however, it is exactly what we should expect to see. The structure of the industry, it’s incentives and our own behavioural foibles combine to make it close to inescapable.
What are the main drivers?
Extrapolation: One of the most damaging investor traits of all and one which Charlie Munger labelled “massively stupid”, is our tendency to extrapolate the past. What has come before will continue. When we persist with buying expensive assets, we ignore the price being paid and simply extrapolate the strong performance into the future. In doing so we ignore every lesson and piece of evidence about capital cycles, valuations and mean reversion. It is why we happily pile our money into thematic ETFs at the peak of stratospheric performance.
Charlie was right.
Narratives: Compounding the problem of extrapolation is the power of narratives. Strong past performance is always accompanied by stories to explain and justify it. This creates a virtuous / vicious circle where stellar returns are given a compelling narrative and that narrative further boosts performance. Expensive assets always have great stories. There is nothing investors love more.
Time Horizons: Most investors operate with time horizons that render valuations irrelevant. By time horizon I don’t mean our ultimate end objective, but the period we care about enough for it to influence our decisions. The latter is typically far shorter than the former. If our patience stretches only to one or two years, then we will rarely notice the importance of the price we pay. Until it is too late.
Career Risk / Incentives: For professional investors, increasing purchases of expensive assets is about the management of career risk. As money flows into the most richly valued areas they become a dominant feature of benchmarks and the main driver of performance. Almost everyone comes to believe that owning more of these assets is obvious. As this phenomenon persists, we have the choice of either joining the party, or losing assets and our jobs. Our incentives are aligned with buying outperforming, expensive assets and funds even if the evidence suggests it is likely to be of detriment to future returns.
Emotions: How we feel has an overwhelming impact on the investment decisions we make. Owning expensive assets is, for the most part, anxiety free. They are performing well, everyone else is buying them and the stories provide validation. For cheaper assets the reverse is true; the narratives are bleak, returns have been poor, and owning them means separating ourselves from the crowd.
Much of our investment activity involves doing things that make us feel good in the moment. We can then repent at leisure.
Overconfidence: We are happy to own assets with stretched valuations even if we acknowledge they are prohibitively expensive because we have an exaggerated belief in our ability to time our exit. We will stay invested whilst things are going well and then change course when things turn sour. Whilst this is an attractive idea, the history of market timing suggests the reality is unlikely to be so favourable.
Studying investor behaviour is typically about identifying the gaps between what we should do and what we actually do, but sometimes it is more profound than that. Our behaviour is often paradoxical.
Consider the following:
The more extreme the outperformance and rich the valuations of an asset class or fund, the greater the likelihood of disappointing returns in the future.
The more extreme the outperformance and rich the valuations of an asset class or fund, the more attracted investors will be to it.*
Given that most investors are seeking to maximise future returns this inconsistency seems absurd, but it is not. Our instincts and environment make the behaviour both damaging and almost inevitable.**
We shouldn’t be asking why do investors chase performance and buy expensive assets but rather, why wouldn’t they?
* Momentum investors get a free pass here because – in the simplest terms possible – chasing strong performance trends is their deliberate process.
** The behaviour won’t persist indefinitely – expensive assets don’t keep attracting assets and outperforming – market conditions will change and valuations will matter again. It is just impossible to predict when.