Missed opportunity?

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This is my first quarterly letter at Fort Pitt Capital Group. I feel privileged to work with such a fine group of professionals, and energized for the journey ahead with you, our clients. I look forward to working with each of you in pursuit of your financial goals. With this in mind, I thought I’d explore one of the themes I’m hearing in my conversations with our investment consultants. They’re seeing a trend toward young people becoming more risk averse. I use “risk averse” to mean avoiding risk even though it results in forgoing significant long-term opportunities. Simply put, younger investors may not be assuming enough risk in their portfolios.

“…younger investors may not be assuming enough risk in their portfolios.”

There is evidence that this is occurring not just here in Pittsburgh, but across the country. In the 2012 Investment Company Fact Book, The Investment Company Institute (ICI) presented the following chart. It shows that young investors nationwide are more risk averse than they were ten years ago. In 2001, approximately 30% of investors under 35 were willing to assume above average risk. After a decade that included two market crashes, increased market volatility and low equity returns, less than 20% in the under-35 group called themselves risk takers:

This change in young investor’s preference is troubling, but not surprising. Traditional financial theory postulates that people are rational thinkers, and make optimal decisions based on all available information. In reality, people oftentimes make decisions based on emotion, or some other cognitive framework developed from recent experience. There is an entire field of finance devoted to studying investment decisions made this way…through a psychological lens rather than a rational one. One observation from this field says we tend to take experiences from our immediate past and extrapolate them into the future. Another says we tend to be more affected by losses than gains. To put it plainly, sometimes we make decisions based on gut instinct rather than the facts, to the detriment of our portfolios.

These behavioral tendencies have been observed in previous generations as well. A study published in the Journal of Economics in 2011 entitled “Depression Babies: Do Macroeconomic Experiences Affect Risk Taking?” examined financial decision-making from 1960 to 2007. It concluded that a person’s level of risk-taking is directly correlated to experienced market returns: “Individuals who have experienced low stock market returns throughout their lives report lower willingness to take financial risk, are less likely to participate in the stock market, invest a lower fraction of their liquid assets in stocks if they participate, and are more pessimistic about future stock returns.” The report added that young people with less stock market experience were more strongly influenced by recent history.

An easy way to measure increased risk aversion is to monitor the flow of money out of stock funds and into bond funds. According to Morningstar, stock funds have seen outflows of approximately $215 billion over the past three years. Bond funds have received net inflows of $728 billion over the same period. This latter number exceeds even the massive flows into equity funds during the “bubble” period of the late 1990s! ICI’s observation in their most recent fact book sums it up well: “Demand for equity funds is strongly related to performance in stock markets. Net flows to equity funds tend to rise with stock prices, and the opposite tends to occur when stock prices fall.” It’s a basic market truism; acting on instinct rather than reason, investors chase gains and flee from losses.

Given these ingrained, generational behaviors, what is a rational investor to do? At Fort Pitt Capital Group, the first thing we do is realize that over long periods of time, capital markets act in a rational and predictable way. One example of this is the concept of the equity premium. This is the idea that over time there is greater financial reward for owning a business rather than lending to a business (or a government, for that matter). The returns from ownership (stocks) are not “guaranteed” like a loan (bonds), so they must be greater over time to justify the risk taken.

If, over an extended period, stock returns don’t outpace bond returns, then interest rates are too high, and likely to fall. The graph below charts the rolling-10-year return of stocks (S&P 500) minus bonds (U.S. Intermediate-Term Treasuries) in the U.S. marketplace. It is essentially a long-term chart of the equity premium. As you can see, there have been only three periods in modern U.S. financial history when the equity premium was negative over a rolling 10-year time frame. Today we’re emerging from just such a period, and the yield on the 10-year U.S. Treasury bond has been falling steadily. In fact, it recently touched a 220-year low!

The next logical question to ask is how well stocks have performed relative to bonds in the periods following a bout of relative outperformance by bonds, such as we’ve seen lately. In other words, does the equity premium typically rise above its long term average after it has been negative for a while? Historically, the answer is yes. The chart to the left shows that the equity premium has averaged 5.06% annually since 1926. It has averaged 5.97% in each of the rolling ten-year periods after turning positive, however. The 0.91% annual difference doesn’t sound like much, but over a decade the 0.91% compounded annually yields an extra $94,818 on a $1 million portfolio. That difference is real money!

The moral of the story is that we can’t know which way stock prices will go this year or next. What we can do, however, is monitor the amount of optimism (or pessimism) in the marketplace as indicated by the level of the equity premium. When it has been negative for a while, that’s likely an indication that investors are down on the stock market and piling into bonds, just as we’re seeing today. Investors, particularly younger ones with time horizons greater than ten years, should take heed and recognize that the market is offering longer-term opportunity. As always with investing, the hard part comes not in crunching the numbers, but in behaving in a manner counter-intuitive to what your gut, and the crowd, may be telling you.

By Todd Douds

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