Your Biggest Advantage Over the Pro in Investing
All the passages below are taken from James Montiier’s book, “The Little Book of Behavioral Investing,” 2010 Edition.
PERHAPS THE MOST OBVIOUS AREA of contact that the public will have with behavioral finance, and certainly the most high profile, is the occurrence of bubbles. According to most standard models of finance, bubbles shouldn't really exist. Yet they have been with us pretty much since time immemorial. The first stock exchange was founded, in 1602. The first equity bubble occurred just 118 years later---the South Sea Bubble. Before that, of course, was the Tulipmania of 1637.
At GMO we define a bubble as a (real) price movement that is at least two standard deviations from trend. Now, if market returns were normally distributed as predicted by the efficient markets hypothesis, a two standard deviation event should occur roughly every 44 years. However, we found a staggering 30 plus bubbles since 1925---that is the equivalent of slightly more than one every three years. Not only did we find such a large number of bubbles, but every single one of the them burst, taking us back down two standard deviations. That should happen once every 2,000 years, not 30 times in 84 years! This is the elephant in the room for those who believe in efficient markets.
There is also a view that bubbles are somehow "black swans." Taleb defined a black swan as a highly improbable event with three principal characteristics:
l. It is unpredictable.
2. It has massive impact.
3. Ex-post, explanations are concocted that make the event appear less random and more predictable than it was.
It would be terribly reassuring if bubbles were black swans; then we would be absolved from our behavior. However, such a defense is largely an abdication of responsibility. The belief that bubbles are black swans has found support at the highest levels. Both Alan Greenspan and Ben Bernanke have been keen proponents of this view as they continually argued that it was impossible to diagnose a bubble before it burst, and hence argued that the best a central bank can do is try and mop up after everything goes wrong.
Why Can't We Time Predictable Surprises?
This is, of course, utter rubbish. It is an attempt to abdicate responsibility. Bubbles and their bursts aren't black swans. They are "predictable surprises."1 This may sound like an oxymoron, but it isn't. Predictable surprises also have three defining characteristics:
1. At least some people are aware of the problem.
2. The problem gets worse over time.
3. Eventually the problem explodes into a crisis, much to the shock of most.
The problem with predictable surprises is that while there is little uncertainty that a large disaster awaits, there is considerable uncertainty over the timing of that disaster.
Take the credit crisis of 2007/8, which has been described by Jeremy Grantham as the most widely predicted crisis of all time. Cacophonies of Cassandras were queuing up to warn of the dangers---even some of the Federal Reserve governors were warning of the problems of lax lending standards. Robert Shiller reissued his book, Irrational Exuberance, in 2005 with a new chapter dedicated to the housing market. Even I (sitting on the other side of the Atlantic) wrote a paper in 2005 arguing that the U.S. housing market showed all the classic hallmarks of a mania.
This discussion of people warning of the danger of the credit bubble might seem odd coming just a few chapters after my rant on the folly of forecasting. However, I think a clear line can be drawn between analysis and forecasting. As Ben Graham put it, "Analysis connotes the careful study of available facts with the attempt to draw conclusions there from based on established principles and sound logic."
So the big question is: What prevents us from seeing these predictable surprises? At least five major psychological hurdles hamper us. Some of these barriers we have already encountered. Firstly, there is our old friend, over-optimism. Everyone simply believes that they are less likely than average to have a drinking problem, to get divorced, or to be fired. This tendency to look on the bright side helps to blind us to the dangers posed by predictable surprises.
In addition to our over-optimism, we suffer from the illusion of control---the belief that we can influence the outcome of uncontrollable events. This is where we encounter a lot of the pseudoscience of finance, things like Valueat-Risk (VaR). The idea that if we can quantify risk then we can control it is one of the great fallacies of modern finance. VaR tells us how much you can expect to lose with a given probability, such as the maximum daily loss with a 95 percent probability. Such risk management techniques are akin to buying a car with an airbag that is guaranteed to work unless you crash. But as we saw earlier, simply providing a number can make people feel safer---the illusion of safety.
We have also encountered the third hurdle to spotting predictable surprises. It is self-serving bias---the innate desire to interpret information and act in ways that are supportive of our own self-interests. The Warren Buffett quotation we used earlier is apposite once again and bears repeating: "Never ask a barber if you need a haircut." If you had been a risk manager in 2006 suggesting that some of the collateralized debt obligations (CDOs) that your bank was working on might have been slightly suspect, you would, of course, have been fired and replaced by a risk manager who was happy to approve the transaction. Whenever lots of people are making lots of money, it is unlikely that they will take a step back and point out the obvious flaws in their actions.
The dot-com bubble in the late 1990s revealed some prime examples of self-serving bias at work. The poster child for poor behavior was Henry Blodget, then of Merrill Lynch. The scale of his hypocrisy was really quite breathtaking. At the same time as he was telling clients in a research report that "We don't see much downside to the shares," he was writing internally that the stock was "such a piece of crap!" He also wrote, "We think LFMN presents an attractive investment" in a report while simultaneously writing, "I can't believe what a POS (piece of shit) that thing is" internally! Of course, Blodget wasn't alone (think Jack Grubman and the likes of Mary Meeker); he was just a particularly egregious example.
The penultimate hurdle is myopia---an overt focus on the short term. All too often we find that consequences that occur at a later date tend to have much less bearing on our choices the further into the future they fall. This can be summed up as "Eat, drink, and be merry, for tomorrow we may die." Of course, this ignores the fact that on any given day we are roughly 260,000 times more likely to be wrong than right with respect to making it to tomorrow. Myopia can be summed up via Saint Augustine's plea, "Lord, make me chaste, but not yet"---one more good year, one more good bonus, and then I promise to go and do something worthwhile with my life, rather than working in finance!
The final barrier to spotting predictable surprises is a form of inattentional blindness. Put bluntly, we simply don't expect to see what we are not looking for. The classic experiment in this field2 shows a short video clip of two teams playing basketball. One team is dressed in white, the other dressed in black. You are asked to count how many times the team in white passed the basketball between themselves. Now half way through this clip a man in a gorilla suit walks on and beats his chest and then walks off. At the end of the clip, you are asked how many passes there were, and the normal range of answers is somewhere between 14 and 17. You are then asked if you saw anything unusual. About 60 percent of people fail to spot the gorilla! When the researcher points out the gorilla, and re-runs the tape, people always say you switched the clip, and the gorilla wasn't there in the first version. Basically, this study demonstrates that people get too caught up in the detail of trying to count the passes. I suspect that something similar happens in finance; investors get caught up in all the details and the noise, and forget to keep an eye on the big picture.
A Beginner's Guide to Spotting Bubbles
So what can we do to improve this sorry state of affairs? Essentially, we must remember Herb Stein's prosaic and prophetic words of wisdom: "If something can't go on forever, it won't." This is a deceptively simple and yet immensely insightful phrase. If markets seem too good to be true, they probably are. Learning to remember this simple fact would help prevent a great deal of the angst caused when the bubble bursts.
A good working knowledge of the history of bubbles can also help preserve your capital. Ben Graham argued that an investor should "have an adequate idea of stock market history, in terms particularly of the major fluctuations. With this background he may be in a position to form some worthwhile judgment of the attractiveness or dangers ... of the market." Nowhere is an appreciation of history more important than in understanding bubbles.
Although the details of bubbles change, the underlying patterns and dynamics are eerily similar. The framework I have long used to think about bubbles has its roots way back in 1867, in a paper written by John Stuart Mill.3 Mill was a quite extraordinary man, a polymath and a polyglot, a philosopher, a poet, an economist, and a Member of Parliament. He was distinctly enlightened in matters of social justice, penning papers which were anti-slavery and pro extended suffrage. From our narrow perspective, it is his work on understanding the patterns of bubbles that is most useful. As Mill put it, "The malady of commercial crisis is not, in essence, a matter of the purse but of the mind."
His model has been used time and again, and forms the basis of the bubble framework utilized by such luminaries as Hyman Minsky, one of the few economists worth listening to, and Charles Kindleberger, the preeminent chronicler of financial manias. Essentially this model breaks a bubble's rise and fall into five phases as shown below.
Displacement -----àCredit creation -----àEuphoria -----àCritical stage/Financial distress -----àRevulsion
Displacement---The birth of a boom.
Displacement is generally an exogenous shock that triggers the creation of profit opportunities in some sectors, while closing down profit availability in other sectors. As long as the opportunities created are greater than those that get shut down, investment and production will pick up to exploit these new opportunities. Investment in both financial and physical assets is likely to occur. Effectively, we are witnessing the birth of a boom. As Mill puts it, "A new confidence begins to germinate early in this period, but its growth is slow."
Credit creation---The nurturing of a bubble.
Just as fire can't grow without oxygen, so a boom needs credit to feed on. Minsky argued that monetary expansion and credit creation are largely endogenous to the system. That is to say, not only can money be created by existing banks but also by the formation of new banks, the development of new credit instruments, and the expansion of personal credit outside the banking system. Mill noted that during this phase "The rate of interest [is] almost uniformly low.... Credit ... continues to grow more robust, enterprise to increase and profits to enlarge."
Euphoria---Everyone starts to buy into the new era.
Prices are seen as only capable of always going up. Traditional valuation standards are abandoned, and new measures are introduced to justify the current price. A wave of over-optimism and overconfidence is unleashed, leading people to overestimate the gains, underestimate the risks, and generally think they can control the situation. The new era dominates discussions, and Sir John Templeton's four most dangerous words in investing, "This time is different," reverberate around the market.
As Mill wrote, "There is a morbid excess of belief ... healthy confidence ... has degenerated into the disease of a too facile faith. ... The crowd of ... investors ... do not, in their excited mood, think of the pertinent questions, whether their capital will become quickly productive, and whether their commitment is out of proportion to their means.... Unfortunately, however, in the absence of adequate foresight and self-control, the tendency is for speculation to attain its most rapid growth exactly when its growth is most dangerous."
Critical stage---Financial distress.
This leads to the critical stage that is often characterized by insiders cashing out, and is rapidly followed by financial distress, in which the excess leverage that has been built up during the boom becomes a major problem. Fraud also often emerges during this stage of the bubble's life.
Mill was aware of the dangers that the use of leverage posed and how it could easily result in asset fire sales. "The ... trader who employs, in addition to his own means, a proportion of borrowed Capital ... has found, in the moment of crisis, the conjuring power of his name utterly vanished, and has been compelled to provide for inexorably maturing obligations by the forced sales of goods or produce at such prices as would tempt forth reluctant capital."
The final stage of a bubble's life cycle is revulsion. Investors are so scarred by the events in which they participated that they can no longer bring themselves to participate in the market at all. This results in bargain basement asset prices.
Mill opined, "As a rule, Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.... The failure of great banks ... and mercantile firms ... are the symptoms incident to the disease, not the disease itself."
Mill was also aware of the prolonged nature of a recovery in the wake of a bubble: "Economy, enforced on great numbers of people by losses from failures and from depreciated investments restricts their purchasing power.... Profits are kept down to the stunted proportions of demand.... Time alone can steady the shattered nerves, and form a healthy cicatrice over wounds so deep."
Pretty much every bubble in history can be mapped against this framework. It should help to guide us in our thinking and analysis when it comes to avoiding bubbles.
Your Edge Over the Pros!
Believe it or not, you actually have one huge edge over the professionals when trying to overcome this pitfall: You don't have to be a slave to an arbitrary benchmark.
As Keynes observed, "It is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy."
According to classical finance, bubbles should be prevented by the presence of arbitrageurs. These guys sit around waiting for opportunities to exploit the herd and drive prices back towards some form of equilibrium. Sadly, not many professional investors actually do this.
Those few who do try to stand against bubbles must avoid the use of leverage. As Mill noted above, those who try to fulfill this role while using leverage often find themselves coming to a sticky end (witness the end of LTCM in 1998). As Keynes said, "The market may remain irrational, longer than you can remain solvent."
Yet, another group of professionals actually chooses to become bubble riders. They amplify rather than reduce the bubble---confident in their abilities to exit at the top or very close to it. Hoare's Bank did exactly this during the South Sea Bubble of 1720, and some hedge funds played a similar role during the dot.com mania.4
However, the vast majority of professional investors simply don't try to arbitrage against bubbles because of self-serving bias and myopia. They are benchmarked against an index and fear underperforming that index above all else (aka career risk); thus they don't have the appetite to stand against bubbles. This is amplified by the fact that most fund management organizations are paid on the basis of assets under management, so the easiest way of not getting fired is to deliver a performance close to the benchmark (aka business risk). These two elements of self-serving bias collude to prevent many managers from "doing the right thing."
Of course thankfully there are exceptions. Jean Marie Eveillard of First Eagle has said "I would rather lose half my clients, than half my client's money." Similarly, Jeremy Grantham's refusal to participate in the dot.com bubble cost him about two-thirds of his asset allocation book. Such a willingness to take on career and business risk is, sadly, a very rare commodity indeed. However, as an individual investor you don't have to worry about career or business risk. This is your greatest advantage over the professionals.
Investors should remember bubbles are a by-product of human behavior, and human behavior is all too predictable. The details of each bubble are subtly different, but the general patterns remain eerily similar. As such, bubbles and their bursts are clearly not black swans. Of course, the timing of the eventual bursting of the bubble remains as uncertain as ever, but the patterns of the events themselves are all too predictable. As Jean Marie Eveillard observed, "Sometimes, what matters is not so much how low the odds are that circumstances would turn negative, what matters more is what the consequences would be if that happens." In other words, sometimes the potentially long term negative outcomes are so severe that investors simply can't afford to ignore them, even in the short term. [pg 129-143]
1. M. Bazerman and M. Watkins, Predictable Surprises: The Disasters You Should Have Seen Coming and How to Prevent Them (Cambridge, MA: Harvard Business Press, 2004).
2. D.J. Simons and C.F. Chabris, "Gorillas in Our Midst: Sustained Inattentional Blindness for Dynamic Events," Perception 28 (1999): 1059-1074.
3. John Stuart Mill, "On Credit Cycles and the Origin of Commercial Panics," Manchester Statistical Society (1867): 11-40.
4. P. Temin and H. Voth, "Riding the South Sea Bubble" (Unpublished paper); and M. Brunnermeier and S. Nagel, "Hedge Funds and the Technology Bubble," Journal of Finance 59 (2004): 2013-2040.