Some investors believe their investment skills are above average because they pick a big winner now and then. This is similar to surveys which reveal that more than 80 percent of drivers believe their abilities to navigate the highways were “above average.” Obviously only 49 percent can be above average by definition. The problem with the human ego is that we attribute successes to our own abilities and failures to randomness or “bad luck.”
For example, most investors, including myself, have in the past used the assumption that their stock portfolio should average about 10 percent return over reasonably long periods of time, because that’s what history has shown equities have produced over the last 80 or 100 years.
Problems arise with this theory when we experience a “dead decade,” like we just went through, where stock returns were approximately zero. For the person getting ready to retire here in 2010, they may not be as ready as they thought they would 10 years ago. The person looking forward to retirement 10 years from now may have a totally different experience if equities return to their winning ways over the next decade. Randomness strikes again.
Financial markets research firm Ibbotson Associates recently compiled data which showed a hypothetical portfolio of 60 percent stocks and 40 percent bonds, in which $100,000 was invested in 1946, would have grown to $1.15 million in 1976, a 8.48 percent APR, while the same investment made in 1976 would have grown to $2.27 million in 2006, a 10.97 percent APR. The luck of when you are in the accumulation years of your life and what the market trends do during that period of time can have a dramatic impact on the final result and your income from investment during your retirement years.
Even a single year could make a difference according to the Ibbotson study. One hundred thousand invested in the hypothetical portfolio in 1964 would have yielded $1.47 million in 1994, 9.37 percent APR but investing the $100,000 in 1965 would have pushed the returns to $1.78 million by 1994, 10.1 percent APR.
The lesson, in my opinion, goes back to some time-tested advice. To deal with randomness — good or bad luck in the financial markets — first acknowledge that when you do well, it is as much or more luck than skill. Don’t become so confident in your own abilities that you subsequently assume too much risk and find out the hard way that like most people, you are probably average as an investor despite your very high level of skill at your chosen profession.
Next, embrace the uncertainty of the future. If you expect uncertainty, you won’t be disappointed and you will probably make more level-headed and disciplined decisions.
Last but not least, invest early and often with a disciplined plan. Despite the effects of randomness, time still helps reduce the risk of the markets, and a disciplined approach to making investment decisions in a conservative practical plan will probably provide the best results over time even with the effects of randomness.
Tom Breiter, president of Breiter Capital Management, Inc., can be reached at (941) 778-1900 or by e-mail at email@example.com.