For those of you with a congenital dislike of public radio, for nearly two decades show host, writer, and (dare I say it) singer Garrison Keillor has produced "A Prairie Home Companion," set in the mythical town of Lake Wobegon, Minnesota. (A small confession: I listened to the show for over two years, before nagging doubts sent me to my Rand McNally to find there was no such place.) Mr. Keillor is heard to intone at the beginning and end of each show that in Lake Wobegon, "all the women are strong, the men are good looking, and the children above average."

Well, on Wall Street everyone's above average too. In case you missed it, there was a piece on investor preconceptions in the September 14 "Abreast of the Market" series in the Wall Street Journal. Writer Greg Ip examined the revision in investor attitudes caused by the third-quarter carnage. Here's his tabulation of the change in investors' return expectations:

Expected Returns	June 1998	Sept. 1998
Next 12 months, own portfolio	15.2%	12.9%
Next 12 months, market overall	13.4%	10.5%
Next 10 years, market overall	(NA)	15.9%

Two things fairly leap out of the table. The first is that the average investor thinks that she will best the market by 2 to 2 1/2 percent. The second is, now that prices are off 15 to 25 percent (depending what market segment you're looking at), the stock returns expected by investors are lower.

Let's examine each proposition in turn. Regarding the first, it is possible that many investors may in fact beat the market by a few percent next year. However, it is of course mathematically impossible for the average investor to do so. In fact, the average investor must of necessity obtain the market return, minus expenses and transaction costs. Even the most casual observer of human nature should not be surprised by this paradox—folks tend to be overconfident. "Overconfidence" is currently a hot topic in behavioral finance circles, and it's worth a brief tour of the subject.

Overconfidence likely has some survival advantage in a state of nature, but not in the world of finance. Consider the following:

• In one study 82 percent of drivers considered themselves in the top 30 percent of their group in terms of safety. (In Sweden, not unsurprisingly, the percentage is much lower.)

• In another study 81 percent of new business owners thought they had a good chance of succeeding, but that only 39 percent of their peers did.

• Several housewives from Beardstown form an investment club, incorrectly calculate their portfolio returns, and then write a bestseller describing the reasons for their "success."

• A neurologist in rural Oregon reads the classic books on portfolio theory and produces a website on the topic.

The factors associated with overconfidence are intriguing . The more complex the task, the more inappropriately overconfident we are. "Calibration" of one's efforts is also a factor. The longer the "feedback loop" between our actions and their "calibration" (receipt of results), the greater our overconfidence. For example, meteorologists, bridge players, and emergency room physicians are quite well calibrated. Investors most certainly are not.

The second observation, that investors reduce their return estimates after sharp market reversals, is on its face even more astonishing. Consider the following question:

On January 1, you buy a gold coin for $300. In the ensuing month the price of gold falls, and your friend then buys an identical coin for $250. Ten years later, you both sell your coins at the same time. Who has earned the higher return?

Very few investors would not chose the correct answer—your friend, having bought his coin for $50 less, will make $50 more than you. Viewed in this context, it is astonishing that any rational investor would impute lower expected returns from falling stock prices. The reason for this is what the behavioral scientists call "expectancy"— we tend to overweight more recent data and underweight older data, even if it is more comprehensive. Had any conversations lately with someone with less than five years investing experience and tried to convince him that he cannot expect 20 percent equity returns over the long term? Blame expectancy. Make the recent data spectacular and/or unpleasant, and it will completely blot out the more important, if abstract, longer term data.

All very interesting, you say, but of what use are such metaphysics? First and foremost, it explains why most investors are "convex" traders. This is a term coined by Sharpe and Perold to describe "portfolio insurance" strategies in which equities are bought as prices rise and sold as they fall. A "concave" strategy represents the opposite—buying as prices fall and selling as they rise. Although some may find one or the other strategy more appealing, Sharpe and Perold make a more profound point: in a world populated by concave traders, it is advantageous to be a convex trader, and vice versa. Financial history in fact suggests that the overwhelming majority of equity investors are convex. This is because of expectancy—when prices rise, investors' estimates of returns irrationally rise, and they buy more. If indeed most investors exhibit such convex behavior, then the rational investor is concave. (Bond investors, on the other hand, appear to be a bit more concave, probably because falling bond prices make the most overt feature of a bond, its current yield, more immediately attractive to the investing public.)

Sharpe and Perold make another point. Markets dominated by convex traders are considerably more volatile than those dominated by concave ones. Which world do you think we've been living in the past several months?

Expectancy and overconfidence have grave implications for the efficient market hypothesis, which is placed firmly on a foundation of investor rationality. Many observers, both in and out of academia, would conclude from the above that this foundation has been built on quicksand. How else to explain an investment climate in which from time to time initial public offerings of companies, most of which will not survive the decade, are priced at astronomical multiples of sales and book value? (Not to mention earnings, as in "what earnings?")

Socrates said that the unexamined life is not worth living. Self-examination is also a profitable investor attribute. Look in the mirror, dear reader. See anything familiar in the above behavioral characteristics?

copyright (c) 1999, William J. Bernstein