Wall Street often mocks Main Street for its lack of investing prowess. But the evidence is mounting that individual investors aren’t so dumb after all.
By Jason Zweig
Illustration: Alex Nabaum
Bit by bit, the myth of the “dumb money” is dying.
For decades, Wall Street has derided individual investors as ill-informed, fickle and hapless. Instead of buying and holding, or buying low and selling high, the “dumb money” blindly chases performance, buying high and selling low. The perennial message from Wall Street: The only way the dumb money can get smart is by taking our advice—at a reasonable fee, of course.
That was always nonsense, but new evidence of its foolishness is piling up fast. A study of clients of Vanguard Group, the giant asset manager, is the latest look at how individual investors make decisions. It shows them, overall, to be patient and prudent. It also offers a hint as to how investors and their financial advisers can get a little smarter still.
One caveat: The study is based on surveys, run every two months since February 2017 among more than 11,000 investors, that measure the views of an unusual group. Vanguard paid for the surveys.
Vanguard’s clients tend to follow the investment gospel preached by the firm’s late founder, John Bogle: Diversify across a few dirt-cheap market-tracking index funds, then hold them for decades. Many of these investors are immunized against the common contagions of performance chasing and itchy-fingered trading.
Wall Street often mocks Main Street for expecting stocks to produce absurdly high future returns. Yet, over time, the average investor in the Vanguard surveys has estimated that stocks would return 5.2% over the coming 12 months and an average of 6.3% annually over the ensuing 10 years. Most professional fund managers would rather chew broken glass than set their expectations that low.
Investors in the study have about 68% in stocks on average. Even when they raise or lower their expectations of future stock returns, they seldom make big trades based on those beliefs: Optimists don’t load up on stock as they get more bullish, and pessimists don’t bail out as they get more bearish.
“They are putting their money where their mouth is, but they’re not betting the ranch on it,” says Matteo Maggiori, an economist at Harvard University. “They’re pretty cautious.” Prof. Maggiori conducted the research along with Stefano Giglio, a finance professor at the Yale School of Management, New York University finance professor Johannes Stroebel and Stephen Utkus, head of the Center for Investor Research at Vanguard.
Over the period covered by the study, U.S. stocks rose steadily, with one 6% decline in early 2018. (The nearly 14% fall in the fourth quarter of 2018 came too recently to be included in the analysis.) Yet most investors didn’t significantly change their portfolios or their expectations.
“The striking thing is that severe fluctuations in stock prices can occur with only marginal results on people’s behavior,” says Mr. Utkus. “It’s almost like people have a belief in stocks, and the intensity of their willingness to change their exposure to them is very muted.”
The Vanguard study also suggests a key clue in determining investors’ tolerance for taking risk.
Advisers often use such factors as age, wealth and professed willingness to lose money to estimate how risky an investor’s portfolio should be.
Older investors in the Vanguard sample do have lower exposure to stocks, with those over the age of 70 keeping about 20 percentage points less of their total holdings in stocks than do those under the age of 40.
Controlling for age and other characteristics, however, wealthier investors don’t take a lot more risk than do those with less money. The top fifth of investors by wealth, who tend to have more than about $800,000 in assets, keep only about 1.3 percentage points more of their portfolios in stocks than do much smaller investors once their age and other demographics are factored in.
What does determine which investors jack up their exposure to stocks or slash it back? Above all, it’s how confident they are that their predictions of stock returns will be proven accurate—along with how frequently they log into their account and how often they trade.
Financial advisers often ask investors to say whether they would buy, sell or hold stocks if the market fell 10%, 20%, 30% or more.
Instead, they should ask investors to predict how much stocks will gain over the coming year and the next decade—and to say how confident they are in their forecasts.
One way to do that, suggests Annie Duke, a decision strategist and author of the outstanding recent book “Thinking in Bets,” is to make them bet on it.
Let’s say you estimate on your adviser’s questionnaire that stocks will return 10% over the next year and an average of 9% annually over the next decade.
Next, says Ms. Duke, you should set a range around each forecast, based on how certain you are. Make it narrow if you’re confident (say, from 8% to 12% and 7% to 11% for the example above). Make it wider if you’re unsure (something like 4% to 16% and 3% to 15%).
Now the clincher: If the final result falls outside your range, you must donate a sum to a charity or political campaign you hate. How much are you willing to bet on that basis?
“Thinking in bets” this way, says Ms. Duke, “gets you to realize that your beliefs have consequences.” It should also help your adviser determine whether you are overconfident—or not confident enough—about returns. That should make you both a little smarter.
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