Image source: Getty Images.

Stocks finished the week strong, with the benchmark S&P 500 (^GSPC -0.95%) and the Dow Jones Industrial Average (^DJI 0.37%) (DJINDICES: $INDU) up 1.42% and 1.32%, respectively on Friday at 3:30 p.m. EDT. It seems investors are satisfied that this morning's employment report for June is in the sweet spot between an economy that continues to move forward with little risk of overheating.

2 key questions prove professional investors are irrational, too

State Street Global Advisors, the investment management arm of State Street Corp, one of the top global custodians, carried out a survey of 400 institutional investors in the context of what it calls the "performance gap" -- the divide between investors' liabilities or spending goals and the low returns on offer in the market. The latter is particularly glaring in bond markets, where roughly $10 trillion, or nearly 40%, of the Bloomberg Global Developed Sovereign Bond Index sport a negative yield.

The respondents, including pension funds, insurance funds, and foundations, were spread across regions and varied in size, with nearly two-thirds managing over $5 billion. Real money, you might say.

Here's what those investors think about the current menu of investment choices (these are benchmark returns; we'll talk about over/under-performance shortly):

Image source: State Street Global Advisors, FT Remark.

A first remark: A 10% return on equities looks optimistic, at least as far as the U.S. is concerned, if you consider that:

  • The historical long-term average on U.S. stocks is less than 10%.
  • The consensus view is that U.S. stocks are fully valued at these prices.

Still, let's put that aside and apply a traditional asset allocation of 60% equities/40% bonds to those return forecasts in order to obtain the expected annualized return on the benchmark portfolio:

(60%) (.10) + (40%) (.055) = .082 = 8.2%

Compared to that benchmark return, how did the investors in the survey expect to perform? I'm glad you asked.

Image source: State Street Global Advisors, FT Remark.

Our Lake Wobegon investors expect to outperform the global benchmark by nearly three percentage points! Keep in mind that if you consider all investors in any market, they cannot, in aggregate, outperform the market, since they are the market. (For more on this obvious, yet critical observation, I recommend John Bogle's excellent essay, The Relentless Rules of Humble Arithmetic.)

You might counter that there are two other asset classes named above that we did not include in our global benchmark, but investors' expectations for their own performance exactly match that of the one they expect to perform best, real estate. In other words, if we want to square investors' answers to the two questions above, we'd have to imagine a world in which investors are fully invested, with their entire portfolios allocated to real estate.

(I'll give you that there are yet other asset classes that were not mentioned in the first question, such as hedge funds or private equity, but it's not unreasonable to assume those asset classes will do no better than real estate, which is also an illiquid "alternative" asset class.)

Obviously, investors have no plans to go "all-in" on real estate, so those 2.7 percentage points of outperformance will need to come from somewhere else: investment skill (professionals call this intangible miracle "alpha"). However, anyone who is a bit familiar with the money management industry knows full well that relying on out-performance amounts to the triumph of optimism over experience (see these results, for example).

Okay, we've had a good laugh pointing out the irrationality of these high-falutin' fund managers, but the point of this exercise wasn't just to amuse. It's time to turn our lens around and ask yourself: Are your expected returns realistic and consistent with your long-term investment goals?

Tweet of the Day

On this day (1932): The market crash of the Great Depression hits bedrock

— Jason Zweig (@jasonzweigwsj) July 8, 2016