Mean Markets and Lizard Brains Read online

  Table of Contents

  Title Page

  Copyright Page

  Preface to the New Edition

  What’s Changed since 2005?

  Notes on This Edition

  Love the Lizard and Prosper

  Preface to the First Edition

  Acknowledgements

  chapter one - INTRODUCTION Mean Markets and Lizard Brains

  Where Should We Invest Our Money?

  The Conventional Wisdom: Bonds Are for Wimps

  Wax On: The Science of Irrationality

  Wax Off: Meet the Lizard Brain

  How to Profit from the New Science of Irrationality

  PART ONE - The New Science of Irrationality

  chapter two - CRAZY PEOPLE Lizard Brains and the New Science of Irrationality

  Do Not Be Afraid to Meet the Lizard Brain

  The Science of Individual Irrationality

  Rocket Scientists Who Can’t Figure

  Split-Brain Investing

  The Lizard Brain Goes to Wall Street

  Irrationality #1: Pride Goeth before a Financial Loss

  Irrationality #2: Fear of Losses Causes Losses

  Irrationality #3: Finding Patterns in Random Walks

  Irrational Nobel Prizes

  chapter three - CRAZY WORLD Mean Markets and the New Science of Irrationality

  How Can a Market Be Mean?

  Are Markets Crazy?

  The Efficient Markets Hypothesis

  If She’s Got Pictures, Deny It! . . .

  Claim #1: Stock Market Crashes

  Photographic Evidence: Asset Bubbles in the Laboratory

  Claim #2: Markets Are More Than Simply Irrational—They Can Be Mean

  Photographic Evidence: Scientific Evidence of Sentiment Predicting Stock Price Changes

  Claim #3: Some People Get Rich by Selling High and Buying Low

  Photographic Evidence: Predicting Coin Flips

  A Hypothesis Masquerading as a Theory

  Why Professors Fly Coach and Speculators Own Jets

  Sell the Fads, Buy the Outcasts

  Job Listing: Street Sweeper to Pick Up Surplus $100 Bills Left Lying in the Street

  The Loneliest Man in San Diego

  An Instinct for Losing Money

  A Guide for Bubble Hunting

  PART TWO - The Old Art of Macroeconomics

  chapter four - U.S. ECONOMIC SNAPSHOT America the Talented Debtor

  Financial Hangover versus the American Spirit

  Bear #1: Animal House Fraternity Goes National

  Bear #2: Financial Hangover

  Bull #1: Economic Eyeglasses for the Short-Sighted

  Bull #2: Vince Lombardi Meets the Computer

  America: The Talented Beggar

  chapter five - INFLATION Rising Prices and Shrinking Dollars

  Return of the Inflationary Monster?

  The Creation of Money: This Kidney Is Not for Sale!

  The Form of Money: Rice, Cheese, Stones, Gold, and Paper

  Shrinking Money: The Trouble with Inflation

  Goldilocks and Inflation that Is “Just Right”

  Yogi Berra and Milton Friedman Share a Pizza

  It’s Good to Be the King

  Reading the Body Language of the Federal Reserve

  Missouri on My Inflationary Mind

  Buy Your Inflation Insurance at Irrationally Low Prices

  Magic Paper

  chapter six - DEFICITS AND DOLLARS Uncle Sam the International Beggar

  Neither a Borrower Nor a Lender Be

  A Euro for Your Thoughts

  Real and Nominal Exchange Rates

  Two Roads to Times Square

  The Country with the Golden Brain

  Loan Sharks and Latin American Defaults

  Where Do We Stand in the Cycle of Irrationality?

  How to Invest in a World with Fluctuating Exchange Rates

  PART THREE - Applying Science and Art to Bonds, Stocks, and Real Estate

  chapter seven - BONDS Are They Only for Wimps?

  U.S. History Has Favored the Bold

  Revenge of the Bond Wimps

  The Mother of All Deficits: Eating Up the World’s Savings?

  The U.S. Annual Budget Deficit and Cumulative Debt in Historical Perspective

  Three Ways to Lose Money in Ultra-Safe U.S. Government Bonds

  How Low Can Interest Rates Go?

  Buying Bonds at the Wrong Time

  Protecting Investments from Changing Interest Rates

  chapter eight - STOCKS For the Long Run or for Losers?

  The Big Pile of Stock Market Cash Visible in the Rearview Mirror

  Why Jeremy Siegel Does Not Play Professional Basketball or Live in East Germany

  Why Jeremy Siegel Does Not Live in Nuclear Winter without Electricity

  U.S. Stocks Have Survived. Are They Expensive Today?

  Natural Limits to Earnings Growth

  Buying the Hype at Precisely the Wrong Time

  Buying Stocks with the Wall Street Bulls

  Reasons to Own Stocks Even If They Are Only Average Investments

  Even If You Do Not Buy Any Stocks, You Own a Lot of Stock

  Our Love Affair with the Stock Market Continues

  chapter nine - REAL ESTATE Live in Your Home; Make Your Money at Work

  Can We Continue to Make Lots of Money on Our Homes?

  The Harvard Economist versus the Gutsy Immigrant

  Is Your Home Overvalued?

  Is There a Housing Bubble?

  Is There a Housing Bubble?

  Solution #1: Plan to Buy a Larger Home in the Future

  Solution #2: Have a Fixed-Rate Mortgage

  Make Your Money at Work; Live in Your Home

  PART FOUR - Profiting from the New Science of Irrationality

  chapter ten - TIMELESS ADVICE How to Shackle the Lizard Brain

  Timeless and Timely Tips

  Why Our Toughest Financial Battles Are with Our Irrational Selves

  Rational and Irrational Apes

  Humans as Zoo Primates

  Neutral Setting: The Lizard Brain Looks Silly in Las Vegas

  Helpful Setting: The Lizard Brain Finds Food in the Kalahari Desert

  Dangerous Setting: The Lizard Brain Loses Money on Wall Street

  Shackle the Lizard Brain Investing Lesson #1: Don’t Trade Emotionally, Unless ...

  Lesson #2: Never Trust Anyone, Not Even Yourself

  Lesson #3: Losers Average Losers

  Lesson #4: Do Not Dollar-Cost Average

  Lesson #5: Do Not Open Your Mutual Fund Statements

  Lesson #6: Spin Control for Yourself

  Lesson #7: When to Go “All In”

  Lesson #8: Do Not Get the Key to the Mini Bar

  Do Not Trade in the Red Zone

  chapter eleven - TIMELY ADVICE Investing in the Meanest of Markets

  A Generation of Rewarding Risk

  The Bull Market of a Lifetime?

  Is It Time to Take Less Financial Risk?

  The Risk of Low-Risk Investing

  The Pain of Low-Risk Investments

  The Barrier to Low-Risk Investing

  How Little Risk Can You Stand?

  Profiting from Manias and Crashes

  Four Keys to Profiting from Mean Markets

  Tame the Lizard Brain and Convert Mean Markets into Opportunity

  Notes

  Index

  Copyright © 2005, 2008 by Terry Burnham. All rights reserved.

  Published by John Wiley & Sons, Inc., Hoboken, New Jersey

  Published simultaneously in Canada

  No part of this publication may be reproduced, stored in a retrieval system, or transmitted in a
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  Limit of Liability/Disclaimer of Warranty: While the publisher and the author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor the author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

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  Library of Congress Cataloging-in-Publication Data:

  Burnham, Terry.

  Mean markets and lizard brains : how to profit from the new science of irrationality / Terry Burnham.—Rev. and updated.

  p. cm.

  Includes bibliographical references and index.

  eISBN : 978-0-470-24524-8

  1. Finance, Personal. 2. Investments. 3. Self-management (Psychology)

  I. Title.

  HG179.B847 2008

  332.6—dc22 2008032214

  Preface to the New Edition

  In January 2005, the first edition of Mean Markets and Lizard Brains made five predictions about the U.S. economy:1. The dollar will fall.

  2. Look out for an end to price stability.

  3. Bonds will wallow.

  4. Stocks will disappoint.

  5. Houses will be a bad investment.

  All five of these predictions have proven correct. Moreover, the economic path has played out exactly as predicted. Finally, the five predictions listed are not a subset of the book’s predictions; the five predictions are the full set.

  Economists are rightly mocked as among the worst forecasters in the world. How did the first edition get everything right? The answer is a combination of luck (certainly) and skill (possibly).

  Luck

  The world contains more luck than our brains are built to believe; after events have happened, they seem inevitable. Thus, when we interpret history, we always place too much emphasis on certainty and not enough on chance. The division between luck and skill is unknowable, but a perfect scorecard such as the one above always involves luck. In addition, the predictions of the first edition were intended to look out over a generation, not just three years. So while it is better to start out being correct, if these predictions fail over the next decade, then they will have been wrong.

  Skill

  The Mean Markets and Lizard Brains predictions were based on a healthy mix of 80% psychology and 20% macroeconomics. I use the “lizard brain” to describe the older, more emotional parts of the human brain. The lizard brain is the most important driver of market irrationality, and it is completely ignored by traditional finance and economics. Thus, predictions that rely on analytic calculations, without an understanding of the lizard brain, are less useful than grandma’s advice or a dart. However, while understanding the lizard brain is central to successful investing, it is not enough. If it were, Sigmund Freud would have been a billionaire.

  With this perspective, Mean Markets and Lizard Brains predicts financial markets by combining the study of the lizard brain with a modest amount of macroeconomics. The analysis adds a bit of economic salt to flavor the psychological stew.

  What’s Changed since 2005?

  In Joseph Heller’s Catch-22, the protagonist, Yossarian, is opposed to war. He is asked, “What if everyone thought like you?” Yossarian responds with, “Then I’d be a damn fool to think any different.” Investing requires being a Yossarian-like contrarian; popular ideas are never profitable. However, the correct response regarding investment consensus is to rephrase Yossarian and say, “I’d be a damn fool to think the same.”

  From the Catch-22 perspective, there have been some troublesome events in the last few years. The predictions of Mean Markets and Lizard Brains were heretical in 2005. These “crazy ideas” have moved from the fringe to the mainstream in 2008. This is very worrying.

  To a contrarian investor, nothing is better than scorn and mockery. For example, I began buying gold in 2002. At my wedding in March of that year (when gold was at $300/ounce), one of my friends literally laughed in my face in disbelief when I disclosed my turn toward gold. While I was a bit hurt by his response, I knew it was a great sign for gold.

  The first edition suggests that 2005 was a perfect storm for financial troubles; kryptonite for the lizard brain. Set up by 20 years of abnormally high returns to risk, the lizard brain had lulled us to sleep. The predictable (and predicted) outcome was a rediscovery of the riskiness of risk. This is precisely what has happened. Now that this idea is becoming popular, a contrarian investor has to feel uneasy. A crowd is no place to make money. I comment more on the worrisome move of the world toward my views in specific chapters of this edition and in the book’s conclusion.

  Notes on This Edition

  This edition contains the original, unaltered text of the 2005 first edition. Politicians and pundits like to change their story to fit the evolving facts. I am confident that my longer-term track record will be far worse than my perfect outcome to date. Nevertheless, I provide clear, unambiguous scorecards for my views by keeping the original text, without even correcting the grammatical errors.

  In addition to the original text, supplemental material has been added at the end of some chapters. Obviously, human nature has not changed in three years so the chapters that cover the lizard brain do not need to be revised. The macroeconomic chapters contain data updates as well as some comments on the evolving market conditions. A good prediction on gold, for example, at $300 requires new comment when gold reaches $1,000.

  Love the Lizard and Prosper

  These remain dangerous times for those who navigate financial markets with unexamined opinions of human nature. The biggest enemy to success lives inside our own skulls within our lizard brains. Learn to embrace, understand, and influence your own lizard brain, and you may, to paraphrase Commander Spock, live long and prosper.

  TERRY BURNHAM

  Cambridge, MA

  June 2008

  Preface to the First Edition

  Mean Markets and Lizard Brains applies a new science of irrationality to personal finance. Conventional financial advice is based on the assumption that both people and markets are rational. New research is uncovering the reasons that real people and actual markets are often crazy. This new work leads to novel insights into how and where to invest.