Most of the whippersnappers in the business don’t even remember the Beardstown Ladies. They were grandmotherly-looking members of an investment club in Beardstown, Illinois who had generated 23% returns on the investment pool for many years. According to an 1998 story in the Wall Street Journal:
The Beardstown Ladies are members of a famous investment club formed in the early 1980s. The ladies rose to prominence in the mid-1990s after the club proclaimed fantastic investment results. For 10-years ending 1993, the club reported a compounded return of 23.4% in their stock portfolio versus 14.9% for the S&P 500. The ladies bought stocks of companies they knew, like McDonald’s and Coke. The investment success propelled the ladies into stardom. They appeared on TV shows and in commercials, spoke on radio programs, and not to miss a moneymaking opportunity, published best selling books on the subject of personal finance and investing. The world changed for the Beardstown ladies in late 1997. A reporter from the Chicago magazine noticed something peculiar about their published investment results. After calculating the numbers several times, he concluded that a gross error had been made. The error was so large, that the accounting firm of Price Waterhouse was called in to clear the air. In the final tally, the clubs worst fears were realized. The ladies’ actual return was only 9.1%, far below the 23.4% they reported, and well below the S&P 500. For years the ladies deposited monthly dues into their account and classified it as an investment gain, rather than additional capital. An embarrassed treasurer blamed the error on her misunderstanding of the computer software the club was using.
Unfortunately it’s not just the Beardstown Ladies who can’t do math. No one questioned the returns initially because they wanted to believe it was true. The exact same error is repeated by most 401k investors who often count their contributions as part of their performance. Even in the absence of contributions, the rest of us favorably mis-remember our results anyway. Psychology Today explains:
What was your portfolio return last calendar year? How did you perform relative to market indexes and other investors? Most investors don’t know the answers to these questions. But their belief in their performance is quite flattering to themselves!
Two interesting studies illustrate this point. In the first study, William Goetzmann and Nadav Peles surveyed a group of investors belonging to the American Association of Individual Investors (AAII) and a group of architects about their retirement plan investment returns. The AAII investors are presumably very knowledgeable about investing from their participation in the association. When asked about their return the previous year, they overestimated their performance by 3.4% (= estimate – actual). Architects are very intelligent with a high degree of education, though they may not be knowledgeable investors. They overestimated their return by 8.6%. Both groups were also asked about their performance relative to a benchmark made up of the same asset allocation. The groups overestimated their relative performance by 5.1% and 4.2%, respectively.
Markus Glaser and Marin Weber also conclude that investors have biased views of their portfolio performance in the past. They surveyed individual investors from a German online brokerage firm and compared their self-assessments to their actual returns over four years. They reported a belief of an annual return mean of 14.9% over the period. Their actual return was more like 3.3%. Now that is overconfidence! In fact, there was no correlation between the actual return and the beliefs about the returns in the sample.
Cognitive dissonance strikes again. According to Goetzmann and Peles in the Psychology Today article:
The authors attribute this to a psychological phenomenon called cognitive dissonance. The investors are mentally distressed by the conflict between a good self-image and empirical evidence of poor choices. To reduce the discomfort, investors adjust their memory about that evidence and those choices. This is then selectively re-enforced by noticing the returns of just their good performing stocks and mutual funds in the portfolio and not the poor ones.
Self-image wins every time. A keen observer will note that investors never vastly underestimate their aggregate returns!
What can we learn from this, other than Germans are the most confident investors on the planet? I’ve bolded the return estimates, just so you can see clearly how large the gap in perception created by cognitive dissonance really is. The bottom line is that we all want to imagine we are getting or can get fantastic returns.
Right now we are smack in the middle of crazy season, where investors are examining their prior year returns and determining whether to stay with their current mutual fund or investment manager. As an investment professional, one of the things you quickly realize is that you are being compared with imaginary numbers–what the client believes you should have done, or what they imagine they would have done! Of course, as discussed above, the imaginary numbers are always terrific.
Cognitive dissonance, I believe, accounts for a lot of the manager turnover in the industry, not just volatility and style rotation. As evidence, consider that according to DALBAR, the average holding period for mutual fund investors is about three years–whether they own a stock fund or a bond fund. The volatility of the average bond fund is probably not enough to shake investors out, but when comparing the bond manager’s actual returns with imaginary returns, investors can only handle three consecutive years of disappointment! Ok, I’m being a little sarcastic here, but this corresponds perfectly with studies of black-box trading systems, which indicate that investors who purchase even a profitable system abandon it after three consecutive losses. (For fans of Markov probability chains, an average of only fourteen coin flips is required to get three heads in a row.)
When it comes to returns, we are all Beardstown Ladies at heart. Our imagined returns are always going to be significantly higher than what we actually get. Keep in mind that, according to the Psychology Today article, there was no correlation between the actual return and the beliefs about the returns. Instead of being bamboozled by your inner Beardstown Lady, step back and really think about your investments. Do they meet your needs? Is the underlying return factor still sound? Keep in mind that the only investment acumen required to actually earn the mutual fund NAV returns is to hold the fund! You don’t have to condemn yourself to DALBAR-type returns. Sure, if something has gone really wrong, you might need to make a gradual change in course–but more often than not, if the return over a multi-year period is in the ballpark, you’re quite possibly better off leaving it alone. If you want to be a successful investor, you need to learn to deal with the real world and not imaginary returns.
Reject your inner Beardstown Lady!