Optimism pays better than pessimism
Long-term performance of stock markets shows perma-bears have negativity bias
“Stock markets suffer frequent declines, but the long-term trend has always been an upward one.” Photograph: Reuters
Stock markets don’t rise all of the time but they do gain most of the time. It generally pays to take the optimistic view, so why are so many financial journalists and investors inclined to pessimism?
Stock markets do suffer frequent declines, but the long-term trend has always been an upward one. In the United States, equities have historically gained in roughly three out of every four years, and there has never been a 20-year period where stocks lost money.
In the UK, stocks have beaten cash in 68 per cent of two-year periods and 75 per cent of five-year periods, according to Barclays’ annual Equity Gilt Study. Over 10 years, UK stocks beat cash 91 per cent of the time; over 18 years, the beat rate rises to 99 per cent. It’s a similar story with bonds, with stocks outperforming the vast majority of the time.
Things aren’t always rosy, and sceptics can point to disasters like Japan, where stocks have halved in value since 1989’s infamous peak. It’s an unarguable fact, however, that stock markets typically rise over time.
You might not guess this from the financial press. Journalists have always tended to be more negative about market declines than they are positive about market gains, according to Prof Diego Garcia. His study The Kinks of Financial Journalism examined market coverage in the New York Times and the Wall Street Journal over the last century, and found it had “barely changed” over that time period, with “virtually all” authors “emphasising negative returns, ignoring large positive market moves”.
Is this a case of “If it bleeds, it leads”? Neither paper is a bastion of sensationalism, so that might be harsh. Rather, this negativity bias is likely driven by more subtle factors.
Earlier this year, Financial Times columnist John Authers, one of the most thoughtful commentators in the investment world, admitted his own writing is likely to be similarly biased towards the negative. Firstly, journalists view themselves as sceptical watchdogs, “the public’s first line of defence against people in the industry trying to oversell them things”. Secondly, “we are far more scared of encouraging readers to buy and ushering them into a loss, than we are of urging them to be cautious, and leading them to miss out on a gain”.
A journalist who tells readers to buy an Enron-like stock would be vilified, said Authers, but no one complains if you tell readers to avoid a stock which goes on to soar in price.
Of course, financial journalists are not the only ones to be guilty of a negativity bias.
Emboldened by the 2008-2009 financial crisis, various perma-bears have spent most of the last eight years warning that overvalued equity markets are headed for another crash of epic proportions. There is a large appetite for apocalyptic commentary, as evidenced by the continued success of doom-laden financial websites such as Zero Hedge and the media attention given to commentators such as Marc “Dr Doom” Faber, who has been warning since 2010 that markets are headed for a 1987-style market crash.
This is an age-old problem. Way back in 1828, John Stuart Mill wrote: “I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.”
The same point is noted by influential Harvard psychologist Steven Pinker, author of The Better Angels of our Nature, which cites a mountain of data showing that, contrary to popular belief, human violence has decreased enormously over the centuries. People tend to be wrongly convinced that the world is going downhill, says Pinker, whose reflections on the psychology of pessimism can also be applied to investors.
The main problem is that pessimism is “intellectually seductive in a way optimism only wishes it could be”, as Morgan Housel from the New York-based Collaborative Fund noted recently. Studies bear out Housel’s contention that pessimism seems smarter than optimism. One study concluded that people who wrote negative book reviews “were perceived as more intelligent, competent, and expert than positive reviewers, even when the content of the positive review was independently judged as being of higher quality and greater forcefulness”. Other studies show when people are asked to impress others with their intelligence, they trot out negative and critical opinions.
Not only are pessimists and critics seen as smarter, they are also seen as more “morally engaged”, says Pinker. Consequently, investors may perceive bullish commentators as superficial salesmen while their bearish brethren are mistaken for forthright truth-tellers.
Thirdly, there is the “bad is stronger than good” effect, as documented by psychologist Roy Baumeister. The pain of a euro lost dwarfs the joy of a euro gained; criticism hurts more than praise encourages; bad information is processed more closely and attentively than good information.
As Baumeister puts it, “bad is stronger than good, as a general principle”, which means investors will almost invariably be excessively tuned into the possibility (however remote) of losing money.
These emotional biases towards pessimism are compounded by a cognitive bias, says Pinker, notably the so-called availability bias documented by behavioural finance expert and Nobel laureate Daniel Kahneman. The availability bias refers to our tendency to make judgments about the likelihood of an event based on how easily an example comes to mind. Time in the market and compound interest drive investment returns. However, that’s not news so it doesn’t readily come to mind. On the other hand, it is news when stocks fall 20 per cent in a single day, as they did on Black Monday in October 1987.
That freak event continues to spook investors, many of whom are unaware that stocks nevertheless finished the year slightly higher.
Being alive to threats helped our ancestors to survive, but this evolutionary impulse is more of a hindrance than a help to investors, who may be better off adapting the optimistic approach preached by investing legend Warren Buffett.
Recently, data scientist and financial planner Michael Toth conducted a sentiment analysis of Buffett’s shareholder letters of the last 40 years, analysing the frequency of positive (for example, “outstanding”, “excellent” and “extraordinary”) and negative (for example, “difficult”, “negative”, “bad”) words. Over the 40 years of letters, only five showed a negative sentiment score, noted Toth.
Buffett’s 2017 shareholder letter was similarly upbeat. “Ever-present naysayers may prosper by marketing their gloomy forecasts,” he said, “but heaven help them if they act on the nonsense they peddle.”
Investors should take note. Pessimism can sound smart, but the history of equity markets suggests optimism pays better.