Divergent Expectations
A Difference in Market Expectations
There is a growing divergence in expected market returns between individual investors and financial professionals. As the gap grows larger, it’s increasingly apparent that there is a disconnect between perceived experiences and real data. Let’s take a look at the differences in market expectations and the potential motivations behind these.
The Influence of Timeline and Perspective
Individual investors are often heavily swayed by recent returns. In behavioral finance, two biases that drive this are anchoring bias and recency bias. Where these biases show up are both in expected returns and money flows. Studies show that individuals tend to place more weight on current prices and observations to make projections going forward. (Our bias is toward markets going up, because statistically, they do… over time). And individual investment tends to flow into funds and strategies that have performed best over some recent time period (e.g top performer for the past 1 year).
On the other hand, financial professionals (though certainly not all) tend to look over the longer term, across different market cycles and think about historical average returns. “Regression toward the mean” is the concept that over the long-term, markets return to average. Just as a baseball player’s hot hitting streak will come to an end and they “regress to the mean.” So, when financial professionals are asked about long-term expectations, they tend to think about long-term averages and place less weight on recent returns.
Expected Returns vs. Real Returns: The Numbers
Natixis Global Asset Management does annual surveys of both individual investors and financial professionals. Their most recent survey highlights a growing expectations gap between individual investors and financial professionals, which is primarily driven by increasing return expectations of individual investors, particularly in the US. Individual investors are expecting long-term real (that is, after inflation) market returns of 17.5%! In contrast, US financial professionals only expect returns of 6.7% above inflation. This leads to a remarkable 161% gap in expectations.
Let’s look at 17.5% expected long-term real returns in the context of US markets since 1928 using the S&P 500 total returns. In 93 years, how often did the market exceed 17.5% annualized real returns?
The research says 26% of the time in any one calendar year.
So, perhaps investors are reasonable. But the survey asked about long-term real returns - not a single year. As you stretch out the time period, this expectation gets progressively unrealistic, and fast!
Over 3-year periods, only 10% of the time did market average more than 17.5%/year.
Over 5-year periods, only 7% of the time.
Finally, over 15-year periods, the market has never provided the return expectations that individual investors currently have, and 15 years isn’t really the long-term.
A Better Investment Expectation
The growing gap in expectations is a clear example of the aforementioned “recency bias.” The strong performance throughout the pandemic has led investors in the US to think that this performance will produce long-term returns we’ve never seen. However, individual investors who are relying upon this high of an annual return to achieve their investment goals are only left with three options:
To experience market returns that have not happened over the last 93 years
To take on very high-level risk in hope that these returns can be achieved
To find themselves disappointed with their investment returns and unable to achieve their financial goals
A good long-term investment plan is built on solid analytical data and realistic expectations around risk and return. Not just recent market return data. While history never repeats itself exactly, in the financial markets, averages have historically been reliable in setting expectations.
