I have written earlier about Expectations Investing. I think I missed out on a related feature. I didn’t write about investor expectations and that is what this post is about.
At the end of the financial year 31st March, 2020, the yearly returns from the Nifty 50 were skewed to the negative side; reason being the benchmark hit its nadir in the last week of March 2020. Fast forward one year from that date and we have a diametrically opposite outcome. The year on year comparison of returns between the last two financial years looks too good be true; and I dare say that for the most part it is so. This has led to a sea change in investor expectations. And, I think that all of us (me included) need a reality check.
Extrapolating the recent past over an uncertain future is something I want to guard against and I think so should everyone else. Over the short-term, (which is anything less than 3 years as per my definition), stocks don’t have to do well in the future, just because they did well in the past. In fact, the opposite might be true. Unfortunately, most investors seem not to realise this; but when it comes to earning money from investing in the stock market, this is a truism. The reason is that, the distribution of stock market returns does not follow the pattern that standard finance theory assumes.
In the case of the Indian stock market, the long-term average returns that the Nifty 50 as an Index has earned for investors is around 14 percent (including dividends). The highlighted words in the previous sentence are specially relevant. Using the words ‘investing’ and ‘long-term’ in the same sentence or context, is a tautology; because investing, by definition should be long-term.
In other words, investors should not expect anything more than 14 percent (including dividends) over the very long-term, when they allocate money to stocks. The long-term average returns of 14 percent that I have mentioned above is since the inception of the Nifty 50 in October 1994. This is long-term average and it is very unlikely to change over the next twenty-five years either. But in the interim, returns can and literally will be all over the place. How can I be so sure of this statistic?
In the stock market, above-average returns tend to offset below-average returns over long time horizons. Statistically, the standard deviation of annualised returns diminishes with time. The distribution of annualised returns consequently converges as the time horizon increases. That is another way of saying that returns from investing in stocks are random for the most part. And the randomness in the returns metric of the stock market tends to fool investors. The question is: Why is it that we are Fooled by the Randomness of stock market returns?
“The speculative public is incorrigible. In financial terms it cannot count beyond 3. It will buy anything, at any price, if there seems to be some “action” in progress. It will fall for any company identified with “franchising,” computers, electronics, science, technology, or what have you, when the particular fashion is raging. Our readers, sensible investors all, are of course above such foolishness.”
Let me unpack my interpretation of what he has said:
- We as Investors are incapable of accepting that anything is random.
- The Stock Market has a random price discovery process. Unfortunately, most of us think that it has a predictable pattern embedded in it. As a result, we perceive patterns where there are none.
- We don’t stop there, we proceed to make forecasts based upon our perceptions, not knowing that our perceptions may be totally wrong to begin with.
- If something happens twice, we expect a third repetition. We mistake correlation for causality.
- The root of the problem lies in the fact that pattern recognition and prediction are a biological imperative. In other words, try as we might, we will continue to be fooled by the randomness of the stock market.
Readers shouldn’t assume that investment returns over the next twelve months will be negative or lower than those of the past twelve months; that is not what I am trying to imply. Neither am I saying that one shouldn’t invest in the Stock Market. My point is that, we shouldn’t invest with inflated expectations, using the previous financial year as the base case. Nobody in their right senses should expect an encore of the last financial year. If it does happen, I don’t have any complaints, but we shouldn’t expect it to. Even if stocks were to return high single digits over the next twelve months, they would still beat every other asset class.
The moral of the story is to keep expectations low when allocating capital. Reason being, over the short-term, the Stock Market returns metric does not lend itself to any pattern. This randomness is commonly known as the price of admission to the stock market. In my opinion, it is worth paying the price.
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