I ended my last blog by referencing an interesting study that demonstrated we humans tend to err on the side of optimism in our lives. Generally, a positive outlook is good for you. It’s probably helped many parents raise their teenaged children to adulthood, for example, without changing the locks on them even once.

But when it comes to expected returns on your investments, it’s best to be as realistic as possible. “The faith in fancifully high returns isn’t just a harmless fairytale,” says Wall Street Journal columnist Jason Zweig in a recent article exploring what financial experts had to say on the subject of market returns. He examined the expectations of trustee-level investors, economic professors, seasoned investment advisors and fellow financial journalists, and received opinions on hoped-for long-term market returns (after inflation, expenses and taxes) ranging from an anemic 0.5 percent per year to a feverish 22 percent per year.  

Overall, the data suggest that most investors’ expectations are too high. Way too high. Zweig cited a 2009 nationwide survey that indicated investors were expecting annual U.S. market returns of 13.7 percent during the next 10 years. He quipped, “What are we smoking, and when will we stop?”

OK, then what sort of long-term return expectations would be realistic for stocks? Lacking a crystal ball, single digits seem a far more prudent assumption than anything even close to double-digits -- especially if inflation stays as low as it is now.

Here’s why. According to financial economics, stock returns are driven by the “equity premium,” which is the amount stocks earn above the risk-free rate of one-month Treasury bills. The risk-free rate, in turn, is the rate earned above inflation. Translating that into a simple equation, it looks approximately like this:

Rate of Inflation + Risk-Free Rate + Equity Premium =
Expected Stock Returns

So what numbers do we plug in? As described above, current inflation rates are around 2.7 percent. Historically, the risk-free rate has earned about 0.7 percent. (It’s a relatively small return, precisely because it’s essentially risk-free.) Conservatively, the equity premium has hovered at around 4.8 percent over long time periods. So plugging in these numbers:

2.7 percent + 0.7 percent + 4.8 percent = 8.2 percent

Will your expected returns be exactly 8.2 percent? Of course not. For one, the math is based on historical returns, and nobody can predict the future so accurately. In addition, most investors temper their equity investments with fixed income, which offers a more stable ride, but also lowers expected returns.

The point is, particularly if inflation stays so low, the average rate of return on stocks over the next 20 years won’t be anywhere near 22 percent. It probably won’t approach the average U.S. investor's expectation of 13.7 percent over the next decade, either. 

Does 8.2 percent sound low to you? If so, consider that this is 5.5 percent more than the current 2.7 percent rate of inflation. That means, with a long-term, compounded rate of return of 8.2 percent for the equity portion of your portfolio, you should still be able to beat inflation by quite a lot and build real wealth through appropriate portfolio construction strategies. In future blogs, I’ll cover some of these techniques. 

Tucked away within the credentials section of my Posey Capital biography is the fact that my academic career includes a bachelor’s degree in psychology. I’ve always been fascinated by the workings of the human mind. Plus, recognizing the tricks our minds play on us helps me advise clients on how to make more rational decisions about their money and their lives.

How do you unwind after a busy day? Personally, I’m a sucker for Science Daily, which I scan regularly for new insights that might (or might not) apply to financial management. Let me share with you a few of my favorite recent posts.

IMPULSE PURCHASES: NOT JUST FOR NEUROTICS ANYMORE (Science Daily, Oct. 20, 2009)

Synopsis: Scientific research says that the more you believe in social equality, the more likely you are to be an impulse buyer.

Investment lesson: If you feel you may be prone to impulse spending, especially if it tends to be beyond your means, it can be a good idea to work with your advisor to develop your ability to assess short-term spending wants versus long-term spending needs.

ARE YOU A GAMBLER? (Science Daily, Jan. 13, 2010)

Synopsis: There is evidence that genetics play a role in our differing attitudes about risk-taking. In a recent study, people with a particular gene were more inclined to take “long-shot” risks (such as playing the lottery) and less inclined to buy insurance.

Investment lesson: Understanding risk and reward in capital markets is key to successful investing, so increasing your familiarity with how you personally feel about risk-taking — and why — might help you make better investment decisions for yourself.

WISHING DOESN’T MAKE IT SO (Science Daily, Jan. 16, 2010)

Synopsis: This study concludes that people think desirable objects are physically closer than they actually are. 

Investment lesson: Avoid falling into the trap of assuming a particular outcome is more likely just because you wish it were so. What do you think the stock market will return over the next 5, 10, 20 years?  Maybe 10–12 percent per year? Think again. I'll address the subject of more realistic return expectations in my next blog.

If you were strolling through the park and a clown wearing purple and yellow polka-dots wheeled past you on his unicycle, you’d probably notice him, right? If you were on a cell phone at the time, think again.

A study published in a recent issue of Applied Cognitive Psychology discovered that 75 percent of the cell phone users in the study suffered from “inattentional blindness.”(1) In other words, three quarters of them did not report seeing the clown.  Now, imagine if you put these same people behind the wheel of an SUV.

Regardless what you think about cell phone use, the study also illustrates how hard it is to keep track of everything at once. Juggling your child’s band practice with picking up cold medicine for your ailing spouse, working over the lunch hour on that critical paperwork, meeting the cable repair company “sometime between 1 pm and 3 pm,” and … Well, you get the idea.

How much time and energy do you have left for thoughtful reflection about your investments?  If you’re like most people, you end up having to make important long-term decisions about your money while surrounded by short-term distractions. To make matters worse, financial news often leaves people feeling as if they must react whenever something particularly good or bad happens in the markets.

Sure, I have my own life’s distractions just as anyone else does, and I enjoy spending time with my wife and our young son every chance I get. But as an independent investment advisor, I am able to devote my entire professional career to keeping clients’ best financial interests at heart, even when they may be incredibly busy with truly important things in their lives, such as taking care of their family or pursuing their personal and professional interests. For example, I can take the time that my clients cannot always find, to carefully consider their investing in a larger context. Wealth management is about more than simply creating piles of money. It also should include planning to spend that money before and during retirement; mitigating unforeseen risks through appropriate insurance coverage; considering the family or philanthropic legacy you hope to build; and more. It’s a career that I love, and I wouldn’t trade it in for the world.

While we’re on the subject of cars, I’d also like to follow up on a blog I posted in late September, in which we offered tips on purchasing cars with minimum hassle. One of our tactics was to distribute a “request for proposal” or “bid” to a variety of dealers in the region before spending our time meeting with them personally. This helped us compare and contrast dealers in an apples-to-apples way, without having to drive all over town. Here’s a fax/e-mail template you can use for this purpose.

I wish you a safe, distraction-free driving experience, for both your car and your wealth!

Before we turn to the business of wealth planning, let’s have some fun. Quick, which square is darker, A or B? (If you need to, click here for a larger view.)

I was astounded (and initially skeptical) to learn they are identical colors! If you don’t believe me, click here for the demonstration of how contrast and shadows can bamboozle our eyes into seeing what simply isn’t there. (Incidentally, this is the same type of trickery that makes the moon seem larger on the horizon, even though we know it’s not.)

Clearly, you can’t always trust your instincts. It’s why airline pilots have to rely on their calibrated instruments along with the view in front of them. Turning to your wealth, it’s why it’s important to heed the academic evidence as much, if not more than, your intuitions about how markets and investing really work.

Consider, for example, a study published in the Journal of Consumer Research, “The Long and Short of it: Why Are Stocks With Shorter Runs Preferred?”¹ The authors demonstrated that investors preferred stocks whose charts display shorter “run lengths” (up-and-down movements) than those with longer run-lengths. Investors tended to perceive that the short-run-length stocks were less risky, regardless of the actual risk involved. Interestingly, the effect grew even stronger among those who were more highly educated and had more trading experience, i.e., those who thought they knew better. (Click here for additional information.)

Like it or not, our minds truly can play some sneaky tricks on us. When viewing Wikipedia games, that can all be in good fun. But when it comes to your wealth it’s serious business, and an illustration of why it’s important to focus on the investment “horizon” — your own long-term goals — rather than the illusion of individual stock charts.

If you're a big saver and your significant other is a big spender (or vice versa), you might be surprised to learn that might have been the very trait that attracted you to them in the first place.  According to a paper written by Scott Rick and Deborah Small of the Wharton School of Finance and Eli Finkel of Northwestern University:

"Surveys of married adults suggest that opposites attract when it comes to emotional reactions toward spending."

Interestingly, it's been found that most single men and women state that they would actually prefer a mate with similar spending habits.  To read the full article, click here.

 One sometimes hears – with ominous overtones for the United States – that democracies last only two hundred years.  Is this limit on the life of a democracy a fact, or an urban legend?  Though often attributed to British lawyer Alexander Tyler, the origin of the saying is unknown.  History offers little support for it, however.   Advocates of the 200-year limit might point out that Athenian democracy lasted about 180 years, from 500 BC to 322 BC.  Nevertheless, other examples are scarce.  Roman democracy, the other obvious example of a representative democracy from the ancient world, lasted from 509-27 BC, or more than 500 years – far in excess of the supposed limit.   A less well-known ancient example of a democracy of Native Americans also contradicts the limit.  The democracy founded by the Iroquois spanned several hundred years.  British democracy can be traced to the English Bill of Rights (1679), and before that to Magna Carta in 1215 – in either case far more than two hundred years ago.   The American (1776) and French Revolutions (1793), 233 and 216 years ago, gave birth to two democracies more than two hundred years ago…and counting.  Obviously no clear evidence foretells the imminent demise of the American and French democracies, and already their longevity is stretching the supposed 200-year rule to the breaking point. Recent history provides no contradictions to the 200-year rule because of course fewer than two hundred years have elapsed. To illustrate, the Japanese and German democracies, along with a number of other modern democracies, have existed only since World War II b just over 60 years. Thus, not enough time has passed for these democracies to test the 200-year limit. In summary, history offers little evidence to support the contention that democracies must fail after two hundred years. Perhaps this urban legend had its roots in the bald speculations of doomsayers who had already concluded that the U.S. is on the decline, who then noticed that the U.S. is about 200 years old, and who figured that the imagined 200-year "rule" would provide convenient support for their own claims that the demise of the U.S. is closer than most think. Some imagine the 207-year Pax Romana, from 27 BC to 180 AD, was an idyllic period of democracy; however, it began with the accession of emperor Augustus Caesar and ended with the death of emperor Marcus Aurelius, and more resembles a dictatorship than a democracy.

In this hour-long interview, Nassim Taleb, originator of the Black Swan hypothesis, argues that investors give too little weight to the risk of statistical “outliers.”  He says that the odds that unlikely events will occur are greater, and their impact is greater, than investors generally perceive.  Daniel Kahneman, well-known authority on behavioral finance, agrees with Taleb’s thesis but argues that the human need for certainty and security will prevent people from perceiving risk differently.  This conversation on perceived risk is especially interesting given the backdrop of the recent upheavals in global financial markets.  A personal note:  Once I got past the first ten minutes, I found the remainder of this hour-long interview intriguing.  The video offers, from an odd quarter, a point of view supporting my typical financial planning advice to avoid excessive portfolio risk and avoid or pay off most indebtedness.  It’s worth a listen if you have the time.  Click here for the video.

Millions of Australians queued up recently for a chance to scoop the nation's biggest jackpot lottery draw.  As a demonstration of hope over experience, it carried uncanny echoes of how many people approach investing.  Click here to read the full article.

United States companies now account for less than half of world stocks.  See at a glance all the investment opportunities in the world.

Do you have most of your stock portfolio in US stocks?  If so, you’re not alone.  Investors worldwide tend to concentrate their investments at home – even when “home” is a very small place.  To illustrate, the average Canadian has about 70% of his investments in stocks of Canadian companies, even though Canadian companies make up less than 3% of world market value.  Does concentrating 70% of your investments in 3% of the market make sense?  No, but the average American shouldn’t be too smug.  Most Americans’ portfolios reflect a similar home bias