Are retail investors' expectations upside down–high when conditions are bad for investing, low when conditions are good? Is there a better way to anticipate what's going to happen to your retirement savings?
Our answers: yes and yes.
There is ample evidence that popular expectations for investment returns are just about the opposite of what would come from a sober analysis of the fundamental data. In 2000, when the market was trading at absurdly high multiples of corporate earnings, funds holding U.S. stocks hauled in $288 billion. In 2002, when stocks were cheap, the inflow slowed to a $13 billion trickle.
The inflow into stock funds dried up once again after the crash of 2007-09 and stayed low for most of the next five years. Now, with stock prices at abnormally high multiples of earnings, the investing masses are putting big money into stock funds.
It's the same with junk bonds. A rational investor would be most likely to buy risky corporate debt when the reward–the yield–is highest and least likely when it is meager. The public is doing just the opposite.
In tumultuous 2008, when junk bond prices were depressed, their yields averaged a 10% premium over safe Treasury paper. That was a good time to be buying. But retail investors were doing more selling than buying. That year junk funds saw $6 billion of net redemptions, not counting reinvestment of dividends, according to data from the Investment Company Institute.
Six years later the prices of risky bonds have recovered, and their yields are correspondingly lower. What are investors doing? They should be selling, but they are not. In 2013, when the yield premium on average was only half that of 2008, investors poured a net $54 billion into junk funds. The money is still coming in ($10 billion in the first four months of this year).
The pattern: If an asset class has done well recently, making its price high, fund buyers want it. If it has done poorly, making it a bargain, they want to sell.
The phenomenon described above anecdotally has been studied statistically. Two Harvard professors, Andrei Shleifer and Robin Greenwood, published a paper last year demonstrating that investor expectations are highest when objective models would say that expected asset returns are lowest, and vice versa.
"People react to salience," says professor Greenwood. "Recent performance is salient." That's a polite way of saying that naive investors navigate with a rearview mirror.
You don't have to make that mistake. There are better ways to come up with a forecast of future returns than to extrapolate the recent past. We'll explore some formulas for stocks, bonds and the funds that own these things.
Experts can differ about how to come up with an expected return from an asset. But one thing they would agree on is that recent performance is a bad indicator of future results. You shouldn't be buying an asset class because it has been going up.
The place to start is with the yield. For a bond, it's the interest yield. For a stock, it's the earnings yield, which is the net income divided by the stock price.
Next, investing costs have to be figured in–both the management fees and the cost impact of turning over a portfolio. If you are buying bonds, you have to allow for inflation. (Shares of stock, in contrast, are not impacted the same way because corporate earnings tend to keep up with inflation.) It's just possible that 401(k) savers don't pay much attention to these things.
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