Expensive Self-Talk For Investors

You’ll encounter a variety of expensive storytellers on your investing journey. Some get paid to sell you stories. Others use stories to sell you investment products. Nefarious characters may use stories that leverage greed and trust to lure investors into fraudulent scams. Those are all expensive stories for those who buy them. However, the storyteller that you will encounter every minute of every day is yourself. You might tell yourself some of the most expensive stories.

Today, I will share some of the common internal dialogues that I have encountered. Not only ones shared with me by others, but tales I have told myself at different times. Along with some data to show why they are expensive to believe in.

The Investing Genius

I feel comfortable betting that you are a smart person. After all, you read The Loonie Doctor. That is not just some self-affirmation exercise. You don’t become a successful professional without brains, drive, and a whole slew of other positive characteristics.

You are used to learning more, working harder, being smarter, and being proactive leading to better results. Specialization works in your career. And gosh-darn-it. People like you.

Unfortunately, that does not translate well into success with investing. Publicly traded markets take the brains and hard work of millions of investors trying to be proactive and predict the future and distill that into the current price. That price is a weighted mean, giving more weight to large players with way more resources than you can access. While not perfectly efficient, the market is efficient enough that you won’t consistently beat it.

---

Stock Picking Data

The best outcome, if you don’t believe me, is to learn this lesson the hard way early on when the money is smaller. That is how I learned that I was not special. My mom lied. Less than 5% of stocks account for all of the market gains. Those fantastic 5% change each decade, and you must pick the next winners in advance. So, the odds are stacked against you. Plus, there is a consequence of failure. The most common outcome for a stock is a catastrophic loss of value without recovery.

That skewed distribution of results with increasing probability of loss the longer you play, but occasional jackpots, is addictive to humans. It is what attracts humans to casinos. Like in a casino, you can have hot streaks. But, the ultimate outcome gravitates toward a loss the more time you spend there. Don’t fool yourself into thinking that you are an investing genius because you have a hot streak.

---

Tactical Adjustments & Market Timing

Even if you use a diversified number of holdings, like a broad market ETF, you can be tempted to place concentrated bets or time movements in and out of positions. Recently, people seem to be flocking to overweight US markets given their recent massive outperformance. The definition of recency bias.

They probably feel like investing geniuses given that it has worked out well over the past year. “Recently” can even span a decade. People forget that Canada outperformed the US from 2003-2013. That wasn’t even that long ago. Outside of the last decade, Canada and the US have had similar long-term returns when you go even further back. They just shift positions at different times.

Longer-term worldwide data back to 1900 shows that the leading markets shift around. The US market has had some luck, but that may change unpredictably in the future. Diversification around the world markets mitigates that uncompensated specific risk. Predicting the future consistently and with enough precision to win at timing different markets has the probable outcome of loss relative to maximizing time in the broad markets.

---

The Cost of Investor Hubris

Despite the data highlighted above, investor hubris persists as an expensive story many of us tell ourselves. We point to other stories of success like Warren Buffet’s long track record. Or maybe even our own hot streak. Markets have evolved since Warren made his biggest gains, but human hubris has remained constant.

Different ways of measuring the cost of investor hubris consistently come up with an average 1-2%/yr. We may easily cost ourselves more by thinking we are investment geniuses than we’d pay to an advisor or the tax collector.

The “Strong Company” Investor

One of the expensive stories that stock pickers tell themselves to justify their belief in stock picking is that they do their research. They read earnings and analyst reports, look at various balance sheet metrics, and only pick the strong companies to invest in. Why get dragged down by all of the crappy companies when you can just buy the strong ones?

The problem with that reasoning is that by the time you pick a “strong company”, the strength is priced in. The discounts on future cash flows are small. So, you pay close to full price. All the reports and metrics that you used to choose that strong company are widely known information. To outperform the market price, the future must unfold in an even better and unexpected fashion.

---

Big & Strong Stocks May Be Over The Hill

There is data to back up this notion. The S&P 500 represents the 500 of the largest companies in the US. There is even a committee component to make it onto the list. They are some of the strongest companies in the world. However, before a stock’s inclusion in the index, most of the gains have already been made.

There may be a bump in price leading up to inclusion in the S&P 500 in anticipation of that event. However, that “index effect” has been shrinking over time and you’d have to identify candidates in advance. After being included in the index, when strength has been proven, the beneficial size, value, and momentum factor weightings contract. The price appreciation moving forward may disappoint in keeping with that.

Another study of companies joining or leaving the vaunted status of the 10 largest US stocks from 1927-2022 showed massive compound returns before joining the top 10. Moving forward, they had flat returns for the following three years and a negative return for periods longer than that. Even strong companies stagnate. They grow old, and many even eventually die. Buying them when everyone sees them strutting around in their prime is a sure way to ride the decline.

---

Quantitative Factors

There are ways to select stocks with characteristics suggestive of outperformance over long time periods. Fama & French identified four factors beyond just market risk. The subsequent disappointing performance after becoming one of the largest companies in a market can be explained by those factors. Smaller size and value (low price to earnings) are factors associated with historical outperformance, and those characteristics shrink with the addition to a large cap index.

It is also important to note that there are factors that you would consider to belong to strong companies. Profitability and conservative investment of capital are factors that have historically predicted the outperformance of the broader market. Dividend-payers and low-volatility stocks may be indirect indicators of those factors. That all said, it is not a free lunch.

A reason why these factors have a premium above the market price is that they are hard to hold. A given factor may underperform the market for long periods of time. Like more than a decade. That is tough to stomach. Just ask people holding a “value tilt” over the last 15 years. They may also get crushed at times when the average investor is also getting crushed in other parts of their economic life. Like recessions. That co-variance is impactful for the pricing of risk in an asset.

The Eeyore Monologues

I previously wrote about how pessimistic narratives sell. Humans are wired to run away from danger more strongly than to run towards profit. Some don’t even need a Doomsday Soothsayer to tell them expensive stories. They have internalized pessimistic views of the financial future. Sadly, those Eeyores are destined to have their glum views crystalized as lost buying power and missing out as the rest of those invested in capital markets march bravely forward. Here are a couple of expensive stories that our internal pessimistic voice whispers to us.

---

Markets Are Dangerous & Scary. GICs are safe.

Of course, markets have risks. That is why they pay you a premium to lure you to invest. It is a “priced risk” for which you can reasonably expect to be compensated in the long run. Provided that you diversify away as much uncompensated risk as possible. For those unable to handle the short-term volatility that is expected along the way, adding some bonds to mitigate behavioral risk helps.

Those who are particularly nervous park their money in cash of GICs. To be clear, I am not talking about saving money that is needed in the near term. That is smart and a GIC is a reasonable option for that. Rather, I am talking about people “investing” their unneeded money using a GIC. This has become particularly prevalent over the past year as GICs have paid respectable nominal interest rates, coupled with high levels of pessimism by the Eyores.

Those GIC owners are probably pretty happy seeing their 5%/yr interest payments. However, it is now tax season. So, let’s reflect on how much money they made after tax. It is easy because interest is fully taxable each year. So, at a 50% marginal rate, that would be 2.5%/yr. Inflation was 3.8% in 2023. So, after taxes and inflation, the happy GIC owner’s buying power eroded by 1.3%. Only an Eyore would love that. Because it is depressing.

Eeyores are surprisingly resilient. If you were to try and crush their spirit by mentioning the 17% nominal return of an all-equity asset allocation ETF in 2023. Mostly as lightly taxed capital gains. They would reply that you’ll be sorry when the impending recession hits. 2023 was just one year, but the long-term track record of a “low-risk” investment, like a 1-month US treasury, barely paces inflation. In Canada, our taxes would mean a guaranteed loss of buying power. The chart below includes many recessions.

---

But What About The Impending Recession?

A frequent topic of conversation for the internal Eyore monologue is the impending recession. For the layperson, a recession is when the economy contracts. That translates into job losses and hardship for many people. There are always some people struggling for the Eyores to point at. With their Eyore lens, some feel like they are in a recession even when things are objectively pretty good. From a numerical standpoint, a recession is characterized by two consecutive quarters of GDP contraction.

Importantly, a recession is only confirmed in retrospect. In contrast, markets are forward-looking. If a recession is brief and shallow, the stock market has often completely recovered by the time a recession is identified. Even if you could identify recessions as they begin in real-time, that is still not a useful predictor of stock market returns. Recently, Ben Felix reviewed the 7 Canadian recessions since 1957 that he has data for. During those recessions, the TSX had positive returns 4 of the 7 times and negative returns 3 times.

What really knocks the stuffing out of the Eeyores is when they finally get excited (in a melancholy way) as a recession does hit and stock markets have declined. Typically, there is a rapid stock market recovery. When Ben looked at the 3-year returns following a peak in GDP followed by the 7 recessions, they were all positive at 3 years (average 6%). At five years, the average for 6 of the 7 recessions was 11% higher.

The seventh recession was in 2020 and the TSX is up by about 30% since that cyclical peak. Of course, that won’t stop the expensive stories that we tell ourselves. Because now the markets are too high!

The Market is Too High

When I started writing this post, everyone was afraid to invest due to the recent market drawdown. Now, as I publish it, people are afraid to invest because markets are at all-time highs (repeatedly). I already showed you a long-term chart in this post. You can deduce from the bottom left to upper right direction of the lines that all-time highs are statistically most likely to be followed by… Wait for it… More all-time highs. The market goes up about 70% of the time.

---

But What About The Near Term?

That is the long-term view. But, what happens in the short term? We just had a double-digit return year. Surely, we tell ourselves, that means that this year will be more muted. Sanity will be restored and the market will drop. The average return is much lower – so there must be a downturn. Maybe I should wait to invest. That is math. There will be another market pullback.

Since you asked nicely, Ben Carlson, of A Wealth of Common Sense has already answered you in this post. The answer is that in the year following an >20% gain of the S&P 500, the gain the following year is most commonly in the double digits too. The subsequent up years averaged almost 19% and those pesky, while the more rare down years averaged -9.1%.

---

I’ll Wait To Buy The Dip

Up is the overall direction, even with the granularity of a couple of years. However, pullbacks and corrections do happen frequently. Unfortunately, you have no idea when. And waiting for the 10% pullback after the market advances 20% still leaves you in the dust. That is also math.

On average, waiting to “buy the dip” has underperformed by ~1-2%/yr overall. In the US market specifically, with an over 90-year dataset, the average underperformance was in the 1.5-3%/yr range. Both overall and in months following all-time highs. That is an expensive story to tell yourself. Again, that opportunity cost is easily within the range of what you could lose to excessive management fees or taxes.

Dealing With Your Self-Talk

In today’s post, I have described some common stories that we tell ourselves. I have also shown data to demonstrate why they are expensive stories if we listen to them. Understanding that helps and feel free to come and look at this post again when you hear expensive self-talk coming from the mirror. It is not easy to ignore.

In addition to your regular therapy sessions here in my office, you should also avoid listening to the various other expensive storytellers on various media or at work. The only thing worse than Eeyore or investing genius monologues is an Eeyore or Genius convention. Whether televised, Tweeted, TikTok’d, YouTubed, or in person.

One cost that I didn’t mention that you can save by not researching about strong companies, the coming recession, or acting out these stories is your time. Go spend time doing something valuable rather than costly.