The old proverb holds that the road to hell is paved with good intentions and it would appear the road to poor investment returns may have a similar motif. According to a recent academic paper by US economics professor Danny Yagan, how people actually end up investing their money can diverge significantly from how they say they plan to invest it.
In Riding the bubble? Chasing returns into illiquid assets, Yagan set out to test the motives of US household – as opposed to institutional – investors when chasing stockmarket returns. He found that households’ reported expectations suggest “they chase returns in order to ‘ride the bubble’ – buying in advance of a temporary stockmarket rally and selling in advance of a temporary decline”.
The implication that household investors do not set out to chase returns into illiquid assets is consistent with other such studies – a striking example being the Yale Stock Market Confidence Index Survey that, in April 2000, found 72% of respondents saying US equities were overvalued yet 76% still expecting the US market to head higher over the next 12 months.
In other words, a mathematical minimum of 48% of respondents – and almost certainly more – thought the market was valued too highly and yet still would have been happy to invest, presumably with the intention of ‘riding’ that bubble – and presumably dismounting before it burst. And yet, according to Yagan’s paper, what people actually end up doing is something else entirely.
The way he went about illustrating this point was to examine flows into and out of a type of US investment known as the ‘fixed annuity’. This bears little resemblance to the variety used in the UK to provide an income in retirement – instead being a tax-free savings product that requires investors to tie up their money for a period of maybe seven or 10 years.
What the paper found is that, when the market has gone down a lot, people tend to commit to these fixed-term and thus illiquid assets where they cannot access their money for the best part of a decade without incurring large fees and/or tax penalties. On the other hand, when the market has gone up a lot, they put their money into equities.
This, as Yagan puts it, is “inconsistent with market-timing motives”. It is also, as we would put it on The Value Perspective, the complete opposite of what investors should be doing, which is buying shares in businesses when they are offered at discount prices. The odd thing here, of course, is these investors do seem to know what they should be doing but their good intentions are stymied by human nature so that they end up behaving irrationally and ignoring valuation.
One explanation for this is the behavioural finance sin of ‘anchoring’, where people extrapolate the future from how things currently are rather than recognising there could be a different environment at some point down the line – and very possibly within those seven or 10 years during which they have tied up their money in illiquid assets.