The Happy Investor
To say that “money isn’t everything” is more than just a cliché. Studies in the early 1970s demonstrated that happiness had not increased in line with income over the previous half-century. Today the developed world is wealthier than ever but ‘how to be happier’ is the most popular course at America’s top 2 universities and books weaving together science and ancient wisdom are commonly best sellers…
So how does this impact us as investors?
According to Mo Gawdat, Chief Business Officer at Google X, and author of Solve for Happy, happiness can be expressed as an equation.
HAPPINESS ≥ Your PERCEPTION of the events of your life, less Your EXPECTATIONS of how life should behave.
According to Gawdat’s model, if you perceive events as equal to or greater than your expectations, then you’re happy – or at least not unhappy!
Investors wanting to increase their wealth and well-being should consider his model. You can’t control many events that affect your portfolio, but events themselves are not part of the equation. Fortunately, you have some control over the two variables driving happiness—your perception of the events and your expectations.
Drill down further as an investor, and your happiness depends on having realistic expectations about investment returns and viewing market events (ups and downs) in the proper context. These two factors can drive your sense of financial well-being and influence your financial outcome.
With this in mind, let’s list some expectation fundamentals in the financial markets.
1. Shares have higher expected returns than safer investments such as Bonds and Cash Deposits.
It is widely known that shares are riskier with investors incentivised to bear that risk with higher expected returns. The higher expected return for shares is known as the equity premium and, historically, it has been about 8% annually in the US. (source DFA – see note 1).
2. All shares don’t have the same expected return.
Research tells us that companies that are smaller and more profitable, with lower relative prices, have higher expected returns than those that are larger and less profitable, with high relative prices.
These patterns are referred to as size, profitability, and value premiums. Your portfolios have extra weighting towards these share types. The premiums have historically ranged from slightly more than 3.5% to just under 5% in the US. (Source DFA – see Note 2).
3. These expected size, profitability, and value premiums are positive but not guaranteed in that the actual realised premiums may be positive in some years and negative in others.
You may even experience a negative premium for several years in a row. The probability of earning a positive premium increases with your time horizon, but it isn’t a sure thing since underperformance is possible over any time frame. Nobel laureate Paul Samuelson said, “In competitive markets there is a buyer for every seller. If one could be sure that a price will rise, it would have already risen.”
The other half of the equation is your perception of an event. Consider an event, such as realising a negative premium over 10 years, a time frame that some investors consider long term. This is not just a hypothetical exercise as it has happened before…and rationally could happen again.
Lengthy periods of underperformance are disappointing, as investors obviously prefer higher rather than lower returns. Nonetheless, disappointment shouldn’t turn into anger or regret if you know in advance that periods like these will occur and recognise you can’t predict them.
Ancient wisdom teaches acceptance, as resistance often fuels anxiety. Instead of resisting periods of underperformance, which might cause you to abandon a well-designed investment plan, try to lean into the outcome. Embrace it by considering that if positive premiums were absolutely certain, even over periods of 10 years or longer, you shouldn’t expect those premiums to materialise going forward.
Why is this?
Because in a well-functioning capital market, competition would drive down expected returns to the levels of other low-risk investments, such as Cash Deposits. Risk and return are related.
The good news is there are sensible and empirically sound ways to increase expected returns. The bad news is there will be periods of underperformance along the way.
Your happiness as an investor depends on how your perception of events stacks up against your expectations. Proper expectations alongside the appropriate perception can help you stay the course and may improve your wealth and well-being.
As David Booth, Executive Chairman and Founder of Dimensional, says, “The most important thing about an investment philosophy is having one you can stick with.”
Source of article: Dimensional Fund Advisors Ltd (DFA). Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.
1. Asset class filters were applied to data retroactively and with the benefit of hindsight. Actual returns may vary. Past performance is no guarantee of future results. In US dollars. Equity premium is the arithmetic average of the annual Fama/French Total US Market Index returns minus the annual one-month US Treasury bills returns. See “Disclosures and Index Descriptions” for additional important information and descriptions of indices used. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.
2. Asset class filters were applied to data retroactively and with the benefit of hindsight. Actual returns may vary. Past performance is no guarantee of future results. In US dollars. Relative price is measured by the price-to-book ratio; value stocks are those with lower price-to-book ratios. Profitability is measured as operating income before depreciation and amortisation minus interest expense scaled by book. Premiums are calculated as the arithmetic average of the annual return differences between indices. Small cap premium: Dimensional US Small Cap Index minus S&P 500 Index. Value premium: Fama/French US Value minus Fama/French US Growth Research Indices. Profitability premium: Dimensional US High Profitability minus Dimensional US Low Profitability Indices.
Their performance does not reflect the expenses associated with the management of an actual portfolio.
Probability of outperformance is computed using 100,000 simulations that bootstrap historical monthly returns from July 1926 to December 2017 for “Market Outperforms Bills” and “Value Outperforms Growth,” from June 1927 to December 2017 for “Small Caps Outperform Large Caps,” and from July 1963 to December 2017 for “High Prof Outperforms Low Prof.” Bootstrapping is a statistical method that relies on random sampling with replacement (i.e., each random sample from a dataset is placed back into the sampling universe before the next sample is taken) to estimate properties of a sample statistic. The projections or other information generated by bootstrapped samples regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Results will vary with each use and over time. See “Disclosures and Index Descriptions” for additional important information and descriptions of indices used.