Debunkery: Learn It, Do It, and Profit From It—Seeing Through Wall Street's Money-Killing Myths

BUNK 42

STOCK RETURNS ARE TOO HIGH AND MUST FALL

Life would be simpler if there were just one, easy-to-diagnose problem causing us to think wrong about investing. Instead, a whole field of behavioral psychology—behavioral finance—evolved to deal with the myriad ways human brains go haywire when contemplating something as unintuitive and unnatural as investing in capital markets.

One common theme that pops up, though, is fear of heights. It’s what makes high P/Es so scary when you look at them in the wrong context (Bunk 26) even though overall P/Es, no matter their level, aren’t predictive of future stock returns over any reasonable time frame, despite persistent myth to the contrary. “Too high” can be framed any number of ways that lead your brain to market ruin. And one is how we look at long-term stock returns.

Scary Scaling

You’ve probably seen Figure 42.1—it’s a simple chart of the S&P 500 Total Return Index going back to 1926. This chart scares the pants off some folks, particularly those who think stocks are unreasonably high now (and at any future point in time) and must crash down to earth. Just look at it! It looks like through history, stocks have had pretty steady returns—then, starting about in 1990, stocks took off and had truly unsustainable returns. Too high! Scary! (On this chart, 1929 doesn’t even show as a blip—which gives you the first clue to its reality.)

Figure 42.1 US Stock Returns, Linear—Looks Are Deceptive

Source: Global Financial Data, Inc., S&P 500 ...