The biggest challenge wealth managers face these days is their clients’ overconfidence, advisor Cullen Roche writes in his Pragmatic Capitalism blog. That’s a problem because it inflates expectations — which, when disappointed, can trigger unhappiness and prompt investors to leave the advisor they blame for letting them down.
Investor overconfidence has two sources: one emotional, the other intellectual. On the emotional side, people tend to think they’re better at things than they actually are. “Surveys find that the majority of people think they’re better-than-average drivers,” writes Cullen, who runs Orcam Financial Group in Encinitas, Calif. In this view, it isn’t simply gains from the stock market’s six-year rally making investors cocky. It’s also their habit of assuming they’ve earned outsize returns by being smart.
On the intellectual side, many investors get overconfident because they don’t know what sort of returns to expect — and don’t have a clue about “real returns.” “You’ve probably heard about how the stock market averages something like a 10% to 12% return annually,” writes Cullen. “But the sad reality is that this commonly cited figure isn’t the return you’re actually going to see in your pocket.”
That’s because stocks are finite in number, and “all outstanding financial assets are held by someone at all times,” Cullen explains. As a result, “there’s a limited quantity of the instruments that generate that 10% to 12% return.” Further, prudent investors keep their portfolios from tracking the market too closely — and tumbling when the market comes under pressure — by owning credit instruments, like bonds, that “don’t generate anything close to that 10% to 12% figure.”
Cullen’s big point — and a message you might want to share with clients — is that reasonable return expectations support thoughtful and sustainable investing. “You have to think in macro terms, or you’re likely to fall into the trap of thinking that the financial markets can achieve something for you that is highly unrealistic,” he writes. “Being realistic about your expectations is the most important step in achieving success in the financial markets.”