Don’t let overconfidence derail investments

Just months after the bull market in stocks became the longest on record, U.S. equity indexes hit new milestones. Fears about the escalation of trade wars, Brexit, and worries about Congress’ ability to raise the U.S. debt ceiling retreated, allowing stocks to power higher.

While many might be celebrating, a new survey points to a disturbing trend among investors: an alarming sense of confidence in future stock market returns.

According to investment bank Natixis, respondents who have at least $100,000 invested say they expect to earn 10.9% above the inflation rate over the long term. That’s higher than the standard 10% that stocks have gained over the long term.

The survey’s result is cause for a major reality check, because anyone who thinks he or she can count on 11% return in the future could be sorely disappointed. In fact, U.S. financial advisers think an annual return of 6.3% is realistic and separately, fund giant Vanguard recently projected 10-year returns for a 60% equity and 40% fixed income portfolio of just 4 to 4.5%.

The likely explanation is “recency bias,” which causes us to pay attention to events that transpired recently in relation to risk and to assume that these trends will always hold. This blinds us to the possibility of a change in the existing pattern.

In this case, respondents have most recently seen stocks rise over the past decade (let’s not recall what happened prior), a trend that they erroneously assume will repeat itself in the future.

Recency bias can expose you to risk that you may come to regret. If you are counting on higher returns, it might lead you to fall short on your retirement savings.

After all, if you plug in 11% on any retirement calculator, it will likely spit out a lower annual savings target. Instead of relying on stocks to do the heavy lifting, the saner approach is to presume that returns will be lower, which would require you to save more during your working years.

If you are pleasantly surprised by better than expected returns, you may be able to call it quits earlier, or (gasp) have more money than you had projected for retirement.

The same survey also revealed unnerving results about investor know-how. While 62% say they know the difference between active and passive investments, it’s not clear that they really do.

Only 49% were aware that index funds are generally cheaper than actively managed funds. According to the Investment Company Institute, in 2018, the average expense ratio of actively managed equity mutual funds was 0.76% versus 0.08% for index equity mutual funds.

Sixty percent say index funds are less risky, and 64% believe index funds will help minimize losses. Given this result, let me say definitively: Index funds are exactly as risky as the underlying indexes in which they are invested.

The wide gap between investor perception and actual knowledge should be a prompt to use the current bull market as an opportunity to educate yourself.

You will thank me when the bear comes out of hibernation!