One of the most widely observed biases amongst investors is overconfidence?

[Marc]

One of the most widely observed biases amongst investors is overconfidence. If you don't think you are overconfident about an investment decision, it's probably because you are overconfident.

We tend to think: Not only will the future be bright, but it will be especially bright for me.

This often leads to poor decision making and a bad investment experience for many. One way that we can seek to protect ourselves from episodes like, say, buying Irish Bank shares in 2007 is by asking these three simple questions.

Let's say it is 2007 and you are talking to the proverbial bloke in the pub who is waxing on about how much money he has made buying shares in Anglo Irish Bank and let's say that you have done a good job of saving and investing all your life and you are coming up to retirement. He says that this is a blue chip investment and a sure thing and that you should give up your boring globally diversified portfolio of low cost index funds and pile in.

Ask yourself this question: say you decide to follow this guy's "advice" and let's say he is right, will it really make that much difference to your life? You are already well off now, and looking forward to a comfortable retirement. Is the possibility of the gain really worth that much to you?

Ok, so now ask yourself a second question. What if you are wrong and Anglo is built on nothing more than cheap money and gambling? What is the downside to you? Can you afford to lose this much? Will you have to keep on working long after you had hoped to retire?

Now, ask yourself one final question - have you ever been wrong before?

By framing our decisions about investments like this, we can avoid some of the more damaging effects of our natural tendencies to make serious investment mistakes.

 

[Chris]

Hi Marc, I like the way you have put this into a few simple questions. I think it is definitely a characteristic that many professional and no-professionals carry.

 

[Bronte]

Ok, so now ask yourself a second question. What if you are wrong and Anglo is built on nothing more than cheap money and gambling?

Anyone who said that in 2007 would have been headed for the looney bin. Hindsight is wonderful.

 

[Marc]

Hi Bronte,

The Anglo example is simply to illustrate the concept rather than a specific outcome.

This idea applies equally to Japanese Equities in 1990, Tech Stocks in 1999, Property syndicates in 2006, or any other event that comes along in the future.

The key is to focus on the question "what if you are wrong" and to focus on the downside risk.

This applies equally to anyone who contemplated buying Apple Shares a few years ago just before the price went up.

You should not judge the prudence of a decision by the outcome but rather by the process you follow.

Gambling on Apple shares is a bad decision, irrespective of the outcome and since you do not know for certain the outcome before you decide to act (as you say - hindsight leads us to believe that the future is easier to predict than it really is) then the best course of action is to act as if you don't know what is going to happen and diversify your investments.

This has always been sound advice and anyone who took this on board in 2007 would have avoided much of the fallout from the Irish Bank shares. Not because we knew what was going to happen, but because they did not know what was going to happen and therefore reducing risk always tends to be a good strategy.

 

[ringledman]

The key to focusing on the downside risk is valuation.

Valuation determines the risk of being wrong whether one is looking at an individual stock or or an index tracker. Starting valuation is the largest determinant of future returns, especially when looking at whole sectors or markets.

Downside risk is reduced by applying a value based approach and diversifying across multiple asset classes, sectors and regions.

 

[shnaek]

'Underconfidence' can lead to the same outcome.
If we think the future doesn't look bright, and seeing as how I'm a saver and investor the future doesn't look especially bright for me.

Let's say that I've done a good job of saving and investing all my life and I am coming up to retirement. But with the money printers running in overdrive, and interest rates on dirt rising rapidly, how can I leave my money in savings?

I am already well off now, and looking forward to a comfortable retirement. But with money becoming less valuable every year, how long will my comfort last? Is the possibility of the loss of spending power worth making some moves? Surely inflation will follow this massive money printing - evidence is all around us, if not so much in official figures. But my health insurance, my electricity, my gas- things I actually use - if they keep rising like this, and the value of my savings keeps falling - do I need to take action?

It really depends on what mindset you are coming from. If you could leave your money in an account and earn a higher rate than inflation then sure, leave it there. You're not any worse off. That position would be a happy one for many of us. Not a reality at present though.

 

[Marc]

This is a really good point.

There is currently what has been described as a "bubble" in risk aversion. But the same logic applies here.

If it were possible for everyone to maintain their standard of living in real terms by holding cash then there would be no reason for anyone to take any risk and global capital markets would cease to function.

 

[Duke of Marmalade]

If it were possible for everyone to maintain their standard of living in real terms by holding cash then there would be no reason for anyone to take any risk and global capital markets would cease to function.

These glib non sequiturs do irk me. In Rory Gillen's book, 3 Steps to Investment Success we are shown a Table where the real returns on Bank Deposits from 1970 to 2011 is given as +1.8% p.a. Capitalists invest to make money. To suggest that their only motivation for so doing is inflation is both trite and unsubstantiated by the past.

He says that this is a blue chip investment and a sure thing and that you should give up your boring globally diversified portfolio of low cost index funds and pile in.

Nothing boring about these at all. One cannot diversify away market risk as anyone who held low cost index funds could painfully testify from the recent financial crisis.

I agree with you on one thing - the utility calculus of your recent retiree with a hard earned nest egg. Another 10% would be nice but not life changing. A 20% hit, even a 10% hit, is wrist slashing territory, and no point in telling her it will all work out in the long term (as JMK reminds us, in the long term we are all dead).

"Globally diversified", "low cost", "inflation the thief", all good sound-bytes to persuade our retiree away from the no brainer State Savings.

 

[Marc]

Duke,

A few comments on your post.

Since 1926 the real inflation adjusted return on US one month Treasury Bills has been 0.54%pa. But this assumes that all savers can save tax free.

Remember that as savers we pay tax before we are hit by inflation and therefore we should really take the Gross nominal return which was 3.53%pa adjust this by an average tax rate (what was this??) it really depends but as far as I can remember I have seen investment tax rates range from 0% to 98% including an investment income surcharge under Jim Calaghan in the the UK.

We need to make an assumption about our average rate of tax lets say it is 30% for the sake of argument. That gives a return of something on the order of 2.47%pa which we need to deflate by an average inflation figure. In the US over this period it averaged 2.98%. Net loss in real terms on an after tax basis.

I also have the data for the UK since 1955, Germany since 1948, Switzerland since 1950. In each case I get a very similar result.

In real terms, cash instruments do not reliably hedge inflation and standards of living on average fall for savers over time.

 

[Marc]

Duke,

My comment about index investing being "boring" was intended to be sarcastic

 

[Marc]

Duke,

Lets hope we are able to pursuade a few retirees to move some of their capital away from the "no brainer of State Savings" as it will ensure higher living standards for everyone overall.

 

[Duke of Marmalade]

Marc it was the grandiose statement that global capital markets would cease to function if cash produced a real return that irked me, as if it is an axiom of our current economic paradigm that cash must get eroded by inflation.

A similar pompous assertion, which I have heard from equity cultists, is that if equities do not outperform in the long run then the economic system, indeed society, as we know it will have broken down.

I was aware, when posting, that penal retail tax rates do make it more difficult for ordinary punters to beat inflation with any investment.

But I still won't buy into a thesis that states "if it were not for tax and inflation eating into cash returns, global capital markets would cease to function"

I accept that there was an element of sarcasm in the use of the word "boring" but I thought the sarcasm was targeted at the "exciting" Anglo proposition.

Others may be lulled into thinking that ETFs are steady dependable creatures. Don't get me wrong, if one must get into equities then low cost globally diversified ETFs certainly fit the bill.

I see those State Savings rates came down quite a lot since I plunged. Marginal advantage but what else is there?

 

[Marc]

Duke,

I actually think this statement is axiomatic.

Think about it like this, if everyone in the world could achieve their desired standard of living saving in a bank account, why would anyone take any risk. Equally in a world where all investment capital was saved with bank deposits why would banks even exist? Nobody would need to borrow money to invest because their would be no investment.

I view this as a simple adding up constraint of an economy in equilibrium.

 

[Duke of Marmalade]

Marc, we will have to agree to differ. I know of no mainstream economic theory that states that the inflation erosion of bank deposits is necessary for global financial markets to function. If you can back up that theory with cogent argument and empirical evidence, go for it, a Nobel Prize awaits.

 

[Marc]

Duke,

I am not saying that. This is simply a restatement of classical economic theory.

The fundamental principle of the classical theory is that the economy is self-regulating. Classical economists maintain that the economy is always capable of achieving the natural level of real GDP or output, which is the level of real GDP that is obtained when the economy's resources are fully employed. While circumstances arise from time to time that cause the economy to fall below or to exceed the natural level of real GDP, self-adjustment mechanisms exist within the market system that work to bring the economy back to the natural level of real GDP. The classical doctrine—that the economy is always at or near the natural level of real GDP—is based on two firmly held beliefs: Say's Law and the belief that prices, wages, and interest rates are flexible.

Aggregate saving is an upward-sloping function of the interest rate; as the interest rate rises, the economy tends to save more. Aggregate investment is a downward-sloping function of the interest rate; as the interest rate rises, the cost of borrowing increases and investment expenditures decline. Initially, aggregate saving and investment are equivalent at the interest rate. If aggregate saving were to increase, causing the S curve to shift to the right, then at the same interest rate i, a gap emerges between investment and savings. Aggregate investment will be lower than aggregate saving, implying that equilibrium real GDP will be below its natural level.

Flexible interest rates, wages, and prices. Classical economists believe that under these circumstances, the interest rate will fall, causing investors to demand more of the available savings. In fact, the interest rate will fall far enough to make the supply of funds from aggregate saving equal to the demand for funds by all investors. Hence, an increase in savings will lead to an increase in investment expenditures through a reduction of the interest rate, and the economy will always return to the natural level of real GDP. The flexibility of the interest rate as well as other prices is the self-adjusting mechanism of the classical theory that ensures that real GDP is always at its natural level. The flexibility of the interest rate keeps the money market, or the market for loanable funds, in equilibrium all the time and thus prevents real GDP from falling below its natural level.

Under these conditions it is therefore changes in the real interest rate that causes the problem for savers a by product of which is negative or close to zero expected real returns for savers relative to investors. This position is certainly reflected in the empirical evidence.

 

[Duke of Marmalade]

Marc, no mention of the "I" word there. A necessary feature of a functioning "money" is that it should act as a store of value. The natural order of things should be that the long term interest rate should be higher than the short term rate to encourage investment and money rates should be higher than inflation to maintain its store of value.

In earlier times this could only be achieved if the money had "intrinsic" superior and endurable value over other goods, the obvious candidate being Gold. But the Gold standard started to interfere with other necessary qualities of money in a modern economy, like its supply should be capable of expanding to meet productivity growth.

These days money is an electronic entry in a bank's ledger. No intrinsic value. It is a key function of the monetary authorities to manage stability across the interest rate range. The cost of money should exceed inflation and should be less than the returns from long term investment over the long term for everything to be honky dory.

In the happy days of the Euro pre crisis, the ECB targeted 2% inflation and had money rates at 4%. Everything was well, and if we ever get out of this mess that will be the natural order of things again.

Rory Gillen has shown that cash deposits have delivered a real return of 1.8% p.a. over the last 40 years.

 

[Marc]

Duke,

I assume you are referring to table 10.2 on page 82 of Rory's book which shows the average rate for Ireland, UK, US and Germany for the period 1970 to 2011?

 

[RichInSpirit]

Gearing and Leverage

The more geared or leveraged you are in any business as well as investing the more money you have the potential to make but also the more you stand to lose if things go against you.

And you could say that you are leveraged the minute you borrow to buy anything such as a house, car, holiday, property, business etc.

 

[Marc]

Duke,

I agree entirely with you that if I move out the yield curve to longer term fixed interest instruments I have a higher expected return as compensation for unexpected inflation. But we are not talking about the bond market, we are talking about demand cash deposits and equivalent.

I have had a look at the numbers in Rory's book and i think there is a problem with the methodology used here to estimate the average real return for cash.

I have run two series on both one month UK and one month US Treasury bills deflated by UK Retail Price Index since 1970.

For the UK I get 1.44%pa real return to the end of 2012 which is within sight of Rory's figure of 1.6%pa.

However, for one month US T bills deflated by UK RPI I get -0.05%pa.

One of the obvious reasons for this is changes in the exchange rate between Sterling and the US$.

But the US$ appreciated against Sterling on average by 0.91%pa

So, all things being equal one month US T bills should have given a higher inflation adjusted return than UK T bills over this period.

But in reality US "cash" gave a lower real return for a UK saver than UK cash over this period.

Was this because "US cash" was less risky than "UK cash" over this period?

UK RPI over this period averaged 6.31%pa whereas US consumer price inflation averaged 4.30%pa so this would certainly seem to support this argument to degree.

My point is that once you factor in these complexities in addition to differences in measures of inflation in different countries, I don't believe that you can simply take the "average" of 4 countries over a relatively short period and conclude that we should base our forward looking expectations on this number of 1.8%pa.

The argument still holds I believe that after tax the real rate of return on cash and near cash instruments (such as demand deposits) is close to zero on average.

Also, we know that on average, average earnings can be expected to increase faster than consumer price inflation and therefore it follows intuitively that even if a saver were able to link their capital and interest to consumer price inflation (through either an inflation linked bond or an inflation linked pension annuity) that their relative standard of living compared to the working population can be expected to decline over time.

This I believe further supports my assertion that it isn't possible for a saver to expect to be able to maintain their relative standard of living and take no risk at all with their capital.

 

[Duke of Marmalade]

Marc it was the original grandiose claim that inflation must erode cash for global financial markets to function that irked. I may have read too much into it and your subsequent extensive explanations all make great sense.

I was myself a bit sceptical about that 1.8% p.a. real return on bank deposits. Not these days for the retail depositor, not after tax and bank intermediation costs. State savings just about make it.

I am glad I am not a financial advisor. For in advising myself I find that I reject all the well argued and researched reasons for, say, investing in an ETF. It's a utility thing. I don't mind risking a few bob on the Saturday's horse racing. But stockmarket risk for meaningful sums? no thanks.