European stock markets slumped on Monday amid renewed sovereign debt fears. Coming on top of recessionary fears for the U.S. economy, investors are fearful again.
Not surprisingly, they flocked to the so-called safety of gold, pushing its price past US$1,900 an ounce for only the second time ever.
Investing in gold has suddenly gone mainstream, so much so that a recent Gallup survey asking Americans what they think is the best long–term investment had gold topping the list, with only 17% of respondents plumping for shares.
With our stock market in the doldrums, and house prices falling, if such a survey existed in Australia, we suspect gold would also be at the top of the list, and probably by some distance.
We’re going to make a prediction. Our prediction is that over the next 10-15 years, reality will prove today’s expectations of the best long-term asset to own painfully wrong.
There are only a few ironclad rules of investing. One is that there’s a negative correlation between sentiment and future returns. When the public expects outsized returns, they practically guarantee otherwise. When people won’t touch an asset because they think it’s toxic, the stage is set for outperformance.
Epic gold rally
Think about gold. The idea of investing in gold was virtually unmentionable 10 years ago. Among other things, that set the stage for an epic rally ever since.
Other recent examples of assets doing the opposite of expectations are powerful.
In 1999, at the peak of the dot com bubble, a survey by the Securities Industry Association showed that investors expected U.S. stocks to return 30% a year going forward. Ever since, they’ve returned roughly 30% less than that.
BusinessWeek penned a cover story headlined “The Death of Equities” in 1979. Reality was the opposite: 1979 was close to the birth year of a two-decade mega-rally.
In May 2008, with oil at US$123 a barrel, Goldman Sachs energy strategist Argun Murti said surging demand was increasingly likely to create a “super-spike” past US$200 in six months-to-two years’ time. Oil now trades at US$83 a barrel, having peaked at US$147.
Today, you don’t have to look far to find some very fanciful predictions about gold. In June this year, Standard Chartered said a supply-demand imbalance could see the price of gold soar to US$5,000 an ounce.
Run through history, and you see the same pattern over and over again. Assets investors are the most bullish on perform miserably in the future, and vice versa.
The reason why isn’t a mystery, though this is a case where psychologists can explain what economists cannot.
Investing through the rear-view mirror
One of the most powerful forces in behavioural finance is called recency bias. It states that when we try to predict the future, we tend to just extrapolate the recent past. If an asset did well in recent years, our expectations of future returns jump. If it crashed in recent years, we give up on its future.
That tendency to chase patterns is natural, but history nearly always plays out the other way.
Periods of above-average returns are invariably followed by periods of below-average returns, and vice versa. This isn’t surprising, since there’s a negative correlation between sentiment and future returns, and sentiment is skewed by recency bias.
The fact that the stock market has performed abysmally and gold has performed incredibly over the past few years leads us to believe the same trend will continue forever more.
A gold plated bet
It won’t. The odds of repeating that performance over the coming decades are extremely low. Since 1820, gold has produced two consecutive decades of positive real returns only once.
Stocks? In the U.S., they’ve never undergone two consecutive decades of negative real returns. When there is a decade in the red, the preceding 10 years have historically brought stock returns of double the average.
If history is any guide, stock returns over the next 10-15 years will be above average, and gold returns will be below average — just the opposite of what the Gallup survey predicts.
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