There are few who would argue that investing for retirement amounts to nothing more than a long-term pursuit to deliver a satisfactory income that enables the aged to maintain something like the lifestyle that they became accustomed to during their working years. The historical evidence shows that the key to delivering on such a goal is to invest heavily in equities when valuations are low and, to put capital elsewhere when stocks are expensive.
Unfortunately, pension funds are rarely managed that way, as the men and women who are paid well to generate investment returns that allow retirees to live out the remainder of their lives in relative comfort, persist with heavy allocations to equities year after year irrespective of price.
In this light, it is important for unsuspecting pension fund clients to be aware of the fact that the recent advance in the world’s major stock market indices has pushed valuations back into nosebleed territory once again. Indeed, reliable measures of valuation in the U.S. suggest that the chances of prices declining in real terms over the next ten years are as much as three-in-four – yet the sell-side on Wall Street is busy raising not only year-end index targets but also their recommended equity allocations. The curious would be right to ask what lies behind such perverse behaviour.
Simply put, the human brain was not designed to understand numbers and the laws of probability appear to be in a class of their own in their ability to create confusion. This fact is demonstrated particularly well by the 1960s American game show – Let’s Make a Deal – hosted by Monty Hall.
At the end of the show, the winning contestant was shown three doors and asked to choose one of them. Behind one of the doors was a major prize, and behind the other two there was a goat. Before revealing what was behind the door the contestant had selected, Monty Hall would open another door to reveal a goat and ask, “Would you like to change your choice?”
Most people believe that the question posed by the host amounts to a coin toss and stick with their original choice. Indeed, just one per cent of all winning contestants elected to switch during the show’s five-year spell on NBC from 1963 to 1968. Unfortunately, the decision to stick is wrong, as switching doubles the odds of winning from one-in-three to two-in-three.
The odds of winning the major prize given the original choice of doors are one-in-three and, the only time that switching will ultimately prove to be a mistake is where the contestant selected the correct door in the first place. In the other two instances, the contestant will have chosen a goat and Monty Hall always opens a door to reveal a goat, which means that two times in three the prize must be behind the remaining door.
The so-called “Monty Hall Problem” created something akin to a national controversy in the U.S. when a reader posed the puzzle to the Parade magazine columnist, Marilyn Von Savant, in 1990. She was inundated with letters that complained of her innumeracy to such extent that the puzzle made the front page of the New York Times the following summer.
A limited ability to grasp the laws of probability had a far more serious effect during OJ Simpson’s murder trial in 1995. The defence lawyer, Alan Dershowitz, attempted to downplay the fact that Simpson was a wife-beater and stated that only 0.1 per cent of the men who physically abuse their wives actually go on to murder them. However, Nicole Brown had been murdered and given this fact, the odds that Simpson was the killer jumped to more than 80 per cent before any consideration of the incriminating evidence that should have put the matter beyond a reasonable doubt.
It is clear that human beings are not equipped to grasp the intricacies of probability theory and, this goes some way in explaining why investment professionals persist with heavy allocations to equities despite the historical evidence which confirms that lofty valuations like those of today almost always leads to poor long-term returns.
It should also be noted that the human brain is wired for the short-term and simply not equipped to make long-term connections. If it was, consumption of fatty foods, tobacco and purchasing stocks at inflated valuations would all be a thing of the past. So long as the professionals persist in their misguided pursuit of short-term returns, those with a value tilt can expect to be amply rewarded over longer horizons.
Previously posted on www.charliefell.com
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