“The great economist John Maynard Keynes once said: ‘Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.’” – John Coumarianos

The whole idea of “efficient markets” and “random walk” theories play out well on paper, they just never have in actual practice. The reality is investors make repeated emotional mistakes which are ultimately driven by the very volatility they are supposed to withstand.

These emotional mistakes, as I have discussed repeatedly in the past, are the biggest reason for underperformance by investors. These behavioral biases can be broadly defined as Loss Aversion, Narrow Framing, Anchoring, Mental Accounting, Lack of Diversification, Herding, Regret, Media Response, and Optimism.

When prices rise on a consistent basis, investors begin viewing stocks as a “no lose proposition which simply deliver high-rates of return over the long-term. The reality has actually been quite different. The chart below shows the real, total return, (inflation and dividends included) versus it’s annualized rate of return using a geometric average.

It took nearly 14-years just to break even and 18-years to generate just a 2.93% compounded annual rate of return since 2000. (If you back out dividends, it was virtually zero.) This is a far cry from the 6-8% annualized return assumptions promised to “buy and hold” investors.

But such a low rate of return should not have been surprising.

What drives stock prices (long-term) is the value of what you pay today for a future share of the company’s earnings in the future. Simply put – “it’s valuations, stupid.”  

Instead of magical lottery tickets that automatically and necessarily reward those who wait, stocks are ownership units of businesses. That’s banal, I know, but everyone seems to forget it. And it means equity returns depend on how much you pay for their future profits, not on how much price volatility you can endure.

Stocks are not so efficiently priced that they are always poised to deliver satisfying returns even over a decade or more, as we’ve just witnessed for 18 years. A glance at future 10-year real returns based on the starting Shiller PE (price relative to past 10 years’ average, inflation-adjusted earnings) in the chart above tells the story. Buying high locks in low returns and vice versa.

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