The curse of high expected returns

There’s a game potential clients and advisors play, and I think everyone loses. Here’s how it usually goes:

Person: What are your expected returns? Advisor A: About 7% annually. Person: Ah, ok, I’ll be in touch. …..

Person: What are your expected returns? Advisor B: About 14% a year. Person: Wow, great, where do I sign?

This might seem fine, and it is quite common. I’d like to convince you this is bad, and we should stop playing.

Photo by Greg Rakozy

The trouble with optimism

First, let’s look at normal people’s return expectations. The average investor expects an annual return of 10.7%, according to a recent study. One in six expects a return of 20% or more. These are dramatically higher than most professional investors’ forecasts.

Where do investors get these dramatically higher expectations? I’d guess from friends, family and social media where people boast about their great wins, but forget to mention their average or bad investments.

Remember the two advisors with very different expected returns? They aren’t suggesting different investments or investment strategies. It’s not outright deception[ref]Well, not always. But advisors do know that clients ask for and compare expected returns, and very well might inflate their expectations to win business.[/ref]. Instead, they’ve got different views on exactly the same investment: one advisor has a more optimistic outlook about the future. As a result, their expected returns are higher. And those higher expected returns are more in line with the normal person’s expectations.

And that leads us to the Winner’s Curse.

The Winner’s Curse says that the winner of an auction probably paid too much. Say a house is auctioned off: there are low and high estimates of its value. Odds are good that the mean estimate is about right. Which means that the winning bid, which will by definition be the highest, is usually too high, so the “winner” overpays[ref]This isn’t a perfect analogy to financial advice, but it is a useful one.[/ref].

Now let’s return to our two advisors. The advisor with the highest expected returns wins the business. At a macro level, if consumers always choose optimistic firms, the less-optimistic ones will go out of business. And now, the returns consumers expect will be too high compared to actual future returns.

That’s bad. But here’s a bigger problem: Those expected returns play a key role in the planning process.

The erosion of financial planning

Your expected returns determine how much you need to save over time to reach a particular target. The higher the expected returns, the less you have to save.

For example, if you want to save $200,000 in 20 years and expect a 10% annual return, you need to put away around $260 every month. If you lower the expected return to 5%, you have to save nearly $490 a month.

The connection between expected returns and financial planning means that clients with more-optimistic advisors are likely to save less. Not having to set aside as much sounds great—until the plan fails because the high returns never materialize.

Perhaps not surprisingly, more than half of people in the study haven’t achieved what they wanted from their investments over the past five years.

Three flawed ideas to avoid the curse

How can we solve this problem? Here are a few imperfect but hopeful ideas:

One Expectation To Rule Them All

Imagine a regulatory or professional oversight body that sets expected returns for all asset classes. In order for an advisor to have different expected returns, they must explain why. This might be their skill in active management or reason that the baseline expectations are wrong.

Could all the stakeholders agree on a valid set of returns? That’s unlikely.

Also, when presented with more realistic (lower) expected returns from advisor, more consumers may embrace DIY investing, believing they can easily get 11% returns.

Derp.

A common calibration

Perhaps all advisors just have to state their expected returns for a common set of indices, from the S&P 500 to the Barclay’s Aggregate. That way, consumers can compare advisors’ expectations against their peers. U.S. Public pension funds already have to do a form of this, and the data is informative.

I really like this idea: it would bring transparency and trackability; journalists and academics could study advisors’ return expectations; and there would be a correction mechanism for over-optimism.

But it’s also probably not likely to happen. Why would businesses impose more audit and accountability on themselves?

Consumer Savviness

Should we expect consumers, who are coming to advisors for expertise on financial plans and investments, to understand the role that they have in causing this problem? Can we educate them to not pick the most attractive option as too-good-to-be-true?

This also seems like wishful thinking.

Knowing about the Winners Curse has made me think about how I might be doing the same thing when I’m the prospective customer. When am I (by my behavior) forcing clients companies to be overly optimistic? Where might relying on short-term ‘bake-offs’ actually hurt me in the long run as I rely on those unviable levels of service persisting.

I’ve realized it’s a bad long-term game, and I want to stop playing.