3 Investment Fallacies I’ve Had to Unlearn

Misled

I cherish history. Not because those who cannot remember the past are doomed to repeat it, although avoiding that fate is often desirable. Nor because memories have become my competitive advantage. Younger researchers have quick minds but few data points on which to operate.

Rather, I am fascinated by the instances when reality and perception diverge. Contemporary observers have difficulty recognizing such situations. However, the passage of time permits us to understand why people thought as they did. Perhaps we can learn from those experiences.

In that spirit, I offer the three overwhelming investment beliefs of the late 1980s, which I immediately encountered upon starting my career. They were all widely known “truths.” They were all false.

Investment Fallacy 1: Social Security’s Demise

I will not belabor this issue, having previously written about it. That said, the upshot bears repeating: The public was very wrong about the future of Social Security. For example, in December 1989, Gallup pollsters asked working adults, “Do you think the Social Security system will be able to pay you a benefit when you retire?” The question was not whether benefits might be trimmed, or whether the system was well-financed, each of which could feasibly have elicited different answers. It was bluntly, “Will you receive a benefit?”

There were only two correct answers to the query: 1) Yes, for those who knew the result of the Social Security Administration’s actuarial studies, or 2) No Opinion, for those who did not. This was clear, as the previous year’s Actuarial Status Report, published by the Social Security Administration, had demonstrated that the Social Security Trust Fund would remain solvent for a bare minimum of 37 years, using the most pessimistic set of assumptions.

The poll’s result, however, was 49% Yes, 47% No, and 4% No Opinion. Almost half the public replied negatively. They had heard somewhere, from somebody, about the program’s troubles. They never did trust the government. Their stockbroker had warned them not to expect their Social Security benefits. There were many ways for them to be mistaken.

And mistaken they were. As the chart below illustrates, not only have Social Security benefits continued unabated, but they have increased after inflation. The news gets even better. Since the late 1980s, Social Security payments have outstripped the growth in real household income. Retirees have fared better than workers since Social Security’s fate was doubted—not worse.

The public’s current belief about Social Security’s future is similar, with a summer 2023 poll eliciting a response of 50% Yes, 47% No, and 3% No Opinion. This time, though, the circumstances are different, as the Social Security Administration projects that the Trust Fund will deplete in 2033. I don’t regard that forecast as terribly threatening, because the Trust Fund is an accounting fiction that can easily be changed by legislation. Still, there’s no question that circumstances have changed, but the public’s views have not.

Investment Fallacy 2: Lower Equity Returns

The consensus was sounder with stocks. It didn’t take a finance degree to realize that equities had recorded higher long-term returns than either bonds or cash. That was well known. When saving for retirement, all experts chimed, buy equities. Their advice was the same as today.

However, I was frequently informed that the stock market’s glory days had come and gone. In 1975, US equities sold for a pittance, a mere 8 times earnings. By early 1988, when I joined Morningstar, that ratio had almost doubled. Great news for existing investors, who had reaped windfall gains. The easy money having already been made, however, my path would be more of a slog.

Not so. Over the next 13 years, from 1988 through 2000, the after-inflation stock market return was far higher than during the previous 13 years. The same principle held when extending the study to encompass my entire investment experience, which commenced in the winter of 1988.

The following graph attests to the evidence. The blue bar on the far left depicts the annualized after-inflation return for US large-company stocks over the 13 years prior to 1988, that is, during the market’s alleged glory years of 1975-87. That total is then compared with the red bar of the stock market’s return for the first 13 years in which I was invested, from 1988 to 2000.

The two bars to the right are similarly constructed, displaying the results of two 36-year periods: 1) 1952-87 and 2) 1988-2023. I held no stocks during the blue bar’s tenure, then always did so during the red bar’s reign.

Lucky me! As it turned out, I was early to the party rather than late. True, US stocks began this millennium poorly, but they have since righted the ship. Their overall gain since I was advised to lower my expectations has been nothing short of spectacular, as their 7.96% annualized return translates to 1,577% cumulatively. In other words, my initial investment is worth almost 16 times its original value after adjusting for the effects of inflation.

As this result has come courtesy of another doubling of the market’s price/earnings ratio, it would be rash to predict that equities will repeat their achievement. This time, I believe, future returns will indeed fail to match those of the past. But I make that statement guardedly. Just as there were more things on heaven and earth that were dreamt of in my predecessors’ philosophies, Horatio, the stock market’s possibilities also exceed my imagination.

Investment Fallacy 3: The Limit of Indexing

I quickly recognized the merits of indexing. In the late 1980s, retail buyers were only dimly aware of passive funds, but institutional investors had already embraced the strategy. The numbers spoke for themselves. By that time, Vanguard 500 Index VFINX had been around for more than a decade, posting competitive results.

I doubted that indexing’s success would repeat in other marketplaces, though. Portfolio managers constantly pointed out that it was one thing to passively invest in well-known US blue chips, but quite another to mimic less-scrutinized marketplaces. With small-company and overseas stocks, or high-yield bonds, research mattered. That made sense to me.

However, it was not correct. I have since learned that investment professionals say many things that sound plausible but cannot withstand close analysis. This was one of them. In fairness, the proposition at that time was very difficult to test, because only the broadest indexes possessed significant track records. The statement was made—or rejected—on faith.

These days, we can replace the angels dancing on the heads of pins with tangible data. And the numbers convincingly refute the argument. The next exhibit compares the annualized returns for six specialty indexes against the relevant Morningstar Category average for active funds, for the 35-year period from 1989 through 2023. Except for the tiny Japan category, the indexes were superior.

To be sure, this evidence does not entirely dismantle active management’s claim. As these are after-cost results, with most of the active funds carrying higher expense ratios than the performance gap, portfolio managers can fairly say that they did seize some investment opportunities. But unfortunately, their insights were not large enough for them to earn their keep.