Mean Markets and Lizard Brains Page 7

  Professor Odean found that markets were mean to these people. The investors studied were completely out of sync with the market. They sold stocks that went up and bought stocks that went down. None of this is supposed to occur if the world ran according to the rules of the efficient markets hypothesis. All stock prices are supposed to be correct, so it should be impossible to make systematically bad choices.

  In an episode of the futuristic cartoon, The Jetsons, there is a mobile, robotic slot machine that rolls around enticing would-be gamblers by saying, “I’m due.” The implication is that no one has hit the jackpot in a while so now is a good moment to invest a few bucks to try to win. The punch line of the scene comes when some lucky gambler actually does win the jackpot. The robot pays out the money and then scoots off proclaiming, “I’m due.”

  In reality, slot machines are never “due.” They are designed to completely forget the past; in the language of probability, slot machines are “memoryless.” The chance of winning immediately after a jackpot is the same as on a slot machine that has gone years without a winner.

  The efficient markets hypothesis states that stock markets should be memoryless like an idealized slot machine. Nothing should predict the next day’s stock price changes. So if it were true that optimism preceded stock (and stock market) declines, then that would be evidence of market irrationality and market meanness.

  The Denial: The believers in the efficient markets hypothesis deny that sentiment provides any information about future price changes. They claim that the evidence of disdain for stocks in the late 1970s (e.g., the “Death of Equities” cover story) is anecdotal and thus not scientific. Professor Odean’s study demonstrating irrationality must be flawed.

  Photographic Evidence: Scientific Evidence of Sentiment Predicting Stock Price Changes

  Professor Richard Thaler, doyen of the behavioral school, and Professor Werner DeBondt performed a systematic analysis of sentiment.16 They hypothesized that people would feel good about rising stocks and feel bad about falling stocks. Therefore, they predicted that the future performance of stocks that made investors feel bad (the losers) would be better than that of stocks that made investors feel good (the winners).

  Professors Thaler and DeBondt thus predicted that a way to make money is precisely to buy the hated stocks that had been losers. They performed a systematic study of hundreds of stocks over many years. In each period they constructed a portfolio of previous winners and previous losers. They then compared the performance of their winner and loser portfolios.

  The rational and irrational views of markets make competing predictions in this situation. If the efficient markets hypothesis were true, then nothing would predict the future changes in price. If the market were rational, then the winners’ portfolio would have the same performance as the losers’ portfolio.

  But Professors Thaler and DeBondt found that individual stocks exhibit the same pattern as the market as a whole: Pessimism precedes rises, and optimism precedes falls. In their words, “Loser portfolios of 35 stocks outperform the market by, on average, 19.6%, thirty six months after portfolio formation. Winner portfolios, on the other hand, earn about 5.0% less than the market.” This study was published in the prestigious Journal of Finance.

  The winner and loser study contradicts the efficient markets hypothesis, which predicts that memoryless markets don’t care about previous performance. Many other behavioral finance studies have produced evidence that contradicts the efficient markets hypothesis. (Professor Thaler collected and published 21 such studies in Advances in Behavioral Finance.17) To which the true believers argue that the studies are contrived and people who trade at irrational prices would be weeded out.

  It wasn’t me.

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

  Over the last 40 years, Warren Buffett has increased the value of Berkshire Hathaway at a compounded rate of 22.2% per year. Over the same period, the S&P 500 stocks have increased by 10.4% a year; $1,000 invested with Warren Buffett at the start of this period would have been worth $2,594,850 at the end of 2003 versus $47,430 for an equivalent investment in the S&P 500.18

  So Warren Buffett seems to have a pretty good record of buying and selling at favorable prices—prices that the efficient markets hypothesis suggests should never exist. Furthermore, Warren Buffett seems to have done a lot better than a dart-throwing monkey.

  Warren Buffett actively seeks undervalued investments. In his 2003 letter to shareholders he writes:

  When valuations are similar, we strongly prefer owning businesses to owning stocks. During most of our years of operations, however, stocks were much the cheaper choice. We therefore sharply tilted our asset allocation in those years towards equities . . . In recent years, however, we’ve found it hard to find significantly undervalued stocks.

  So Warren Buffett believes that undervalued stocks sometimes exist. He also says that there are not many good values in the stock market these days. If the efficient markets hypothesis were true, there would not be any better or worse time to buy stocks; all prices would be fair at all times. So Warren Buffett has made his fortune by acting precisely in a fashion that would be silly if markets were rational.

  The Denial: The believers in the efficient markets hypothesis deny that Warren Buffett’s success is due to skill. Their argument is as follows: Put 1,024 people in a room. Have each of them flip a coin 10 times. On average, one of them will have produced 10 heads in a row. Now call that person Warren Buffett.

  In other words, there are lots of money managers and by sheer dumb luck someone will have a great track record. That great track record, in this view, predicts nothing about the future.

  Photographic Evidence: Predicting Coin Flips

  If Warren Buffett’s success in the past was luck, then the efficient markets hypothesis suggests that for next year he is not expected to outperform the market or a dart-throwing monkey. In this thought experiment the “winner” who produces 10 heads in a row has exactly a 50% chance of producing an eleventh head on the next coin flip, the same odds as a loser who produced 10 tails in a row.

  Professor Thaler has created a money management firm (run with Russell Fuller) that seeks to systematically exploit irrational market opportunities. The firm makes investment decisions guided by the findings of behavioral finance. Although the firm is young, the results are interesting; as of the end of 2003, the firm’s six funds are outperforming their benchmarks by an average of 8.1% a year.19 To which the true believers argue that the performance of these funds, like the performance of Warren Buffett, is luck and not skill.

  No one can really know if a particular performance is due to skill or luck. However, the interesting point is that the efficient markets hypothesis cannot be proven false by any investor’s performance. Regardless of how many more good years Warren Buffett or Fuller-Thaler have, defenders of the efficient markets hypothesis can argue that superior performance is sheer luck.

  It wasn’t me.

  A Hypothesis Masquerading as a Theory

  During the War of 1812, the Native American Chief Tecumseh captured the fort of Detroit through an interesting ruse. In the conflict, federal and state troops, under the command of Major-General Hull, vastly outnumbered about 1,000 Native American warriors. Tecumseh had his fighters run out of the woods and then secretly circle back to emerge again. General Hull saw—and counted—the same warriors over and over and was fooled into thinking he faced a vastly larger force. He surrendered without a shot.

  In any endeavor it is important to have an accurate estimate of the opposition. General Hull gave up before the fight started because he treated a small force like an army. Similarly, the idea that markets are efficient is at best a hypothesis, which is a weak statement. Investors who surrender to dreams of market efficiency give up before the investing battle has begun.

  Proven scientific views of the world are called theories. For example, all of us know that gravity is true, yet it is ca
tegorized as a theory. In contrast to proven theories, new ideas that may or may not be true are labeled “hypotheses.” Importantly, even those who defend market rationality label their idea as only a hypothesis, acknowledging that it has not been proven.

  In fact, the belief in market efficiency might not even qualify for hypothesis status. The great philosopher of science, Sir Karl Popper, writes, “In so far as a scientific statement speaks about reality, it must be falsifiable; and in so far as it is not falsifiable, it does not speak about reality.”20

  In order to reach the standard of hypothesis, an idea must be provable, which means that there must potentially be evidence that could disprove it. As we have seen, there is essentially no way to disprove the idea of efficient markets. Popper excludes unfalsifiable ideas as being outside of science, mere dogma.

  “Double, double toil and trouble; Fire burn, and cauldron bubble,” say the witches in Macbeth, associating bubbles with troubles. However, these same witches also note that in some situations “foul is fair and fair is foul.” When someone sells a house to buy a ridiculously expensive tulip bulb, for example, another person gets to buy a house for the rock-bottom price of one tulip bulb.

  Investors who accept the dogma of market efficiency give up the opportunities that exist precisely because markets are irrational. Such surrender might be merited if the idea of market efficiency were a proven theory, but it is at best a hypothesis, and at worst a nonscientific assertion.

  Why Professors Fly Coach and Speculators Own Jets

  “I have made my living from market inefficiency,” so the financier Alfred Checchi told me during a visit to my Harvard Business School classroom. In contrast, most of the professors at the Harvard Business School are believers in market efficiency, and one told me (with apparent sincerity) that technology stocks were not overpriced in 2000.

  Although Mr. Checchi is frequently invited to visit the Harvard Business School, he is so offended by the assumption of market efficiency that he refuses to attend finance classes. (Similarly, the Nobel Prize-winning economist Professor Ronald Coase told me that his only objection to the idea of “bounded rationality” is that the word “rational” should not be used in any sentence describing human behavior.)

  So who has been more successful in finding market opportunity, efficiency-preaching professors or irrationality-exploiting financiers? Alfred Checchi was able to spend $30 million of his own money on a run for governor in California. Furthermore, while professors usually fly on commercial airlines, Alfred Checchi’s success not only provided him with enough money to buy a private jet, it even allowed him to buy a substantial stake in Northwest Airlines.

  The lesson is that those who seek profit should stop looking for absolute proof that markets are not efficient. Such proof is not possible. In contrast, those who seek superior performance should, like Mr. Checchi, accept market irrationality as the first step toward profit.

  Furthermore, Mr. Checchi shows that crazy markets don’t have to be mean. They can, in fact, be very nice. The key is to be on the right side of irrationality—to sell at high prices and buy at low prices.

  Sell the Fads, Buy the Outcasts

  Opportunities occur periodically in many different markets. In all cases, winning requires a willingness to challenge the conventional wisdom. During the inflationary 1970s, Andrew Tobias, the personal finance guru, literally had to deal with a mob in order to profit from an irrationally high silver price.21

  Throughout the inflationary 1970s the price of silver rose by more than 1,000% until it exceeded $40 an ounce. At the height of the frenzy, Tobias decided to sell some of his physical silver. He went to a retail location that bought and sold precious metals including silver and gold. As he approached the store he saw a huge crowd and thought it was too late. Everyone, he supposed, had realized that the price of silver was too high and had gathered to sell.

  When Tobias reached the store he discovered to his delight that the crowd was gathering to buy! Soon afterwards, silver prices plummeted, and more than 20 years later silver still sells for under $10 an ounce. Similarly, in the 1970s gold prices soared toward $900 ounce before crashing, and today it sells for less than half that price.

  In the late 1970s precious metals were the investment craze, and they were terrible investments. In order to profit, Tobias had to lean into the prevailing opinion by selling while all of those around him were buying.

  Usually, the mob is not physically present, but rather represented in the prevailing views of “the knowledgeable.” In 2000, I began dating Barbara. As a joke, I told Barbara that we would have enough money to get married and have a baby if the stock price of EMC fell from $100 to below $50 (I was betting against EMC’s stock price by shorting the shares).

  Barbara is an archeologist and before this baby challenge she had never paid any attention to financial media. Now she began to listen, and the more she learned about EMC, the more she worried. Every single mention of the stock, in every venue, detailed the virtues of the EMC and predicted that the shares would continue to rise. Wall Street analysts and mutual fund managers appeared on TV and described how EMC’s markets were growing and the stock was a “no-brainer,” and a “must own.”

  Under the deluge of praise, Barbara asked me what I knew that these pundits did not. Did I think EMC had bad products? No. Did I have some inside information that EMC sales were bad? No. Did I know of competitors that would steal EMC’s customers? No. Well, she demanded, what did I know? I told Barbara that I knew all the analysts and mutual fund managers loved EMC and that was enough. Barbara responded with “that is so Zen.” With universal praise and love, the stock had nowhere to go but down, and down it went from over $100 a share to below $4.

  The story of precious metals in the 1970s, and EMC more recently, form a universal pattern. Both Wall Street and Main Street have an amazing ability to be wrong about investments. At about the same time that Andrew Tobias was selling silver at ridiculously high prices, unloved stocks were being sold for rock-bottom prices.

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

  This is one of the job descriptions that you will never see posted. For obvious reasons, $100 bills cannot remain visible for long. Because $100 bills tend to get picked up, believers in efficient markets assume that they can’t exist. An alternative, however, is that there are opportunities to make profits, but they persist only in what can be thought of as the lizard brain’s financial blind spots.

  Market opportunities will be difficult to find. There are no easy roads to making money. In The Godfather: Part II, a young Vito Corleone does the favor of hiding some guns for his neighbor Clemenza (Vito goes on to become the Don and Clemenza one of his trusted lieutenants). After the guns are returned, Clemenza says, “A friend of mine has a nice rug. Maybe your wife would like it. . . . It would be a present. I know how to return a favor.”

  As the two men go to pick up the rug from the “friend’s” house, it becomes clear that they are actually stealing. In the process, a policeman comes to the door and Clemenza prepares to shoot the officer. Fortunately, the scene resolves itself without any violence, but the quest for possessions, whether by legal or illegal means, isn’t an easy one.

  While the $100 bills we seek are not easy to find, interestingly sometimes the hardest things to spot are those hiding in plain sight. For example, with modern electronic-search capabilities, the FBI can track most people down very easily. Special agents enter some information about the suspect into the computer, click a few keys, and voila, the suspect is found. Among the hardest to find, however, are people with common names like John Smith. So one of the few ways left to hide from the FBI is to hide in plain view, by being part of a crowd. This problem has complicated U.S. efforts to prevent bombers from boarding planes. There are a large number of people, for example, with the name Mohammad. Thus, many international flights have been canceled because of mistaken identity.

  In the case
of markets, the opportunities exist, but the lizard brain is built not to be able to see them. During the dot-com bubble, the unprofitable Internet retailer eToys was worth more than the profitable, and much larger, Toys R Us. Recognizing that eToys was irrationally priced (and in fact soon went out of business) didn’t require any fancy math.

  While profitable investing doesn’t require mathematical prowess, it does require a willingness to learn about the irrationality in oneself, in others, and in markets. Becoming a successful investor requires a keen understanding of human frailty, including one’s own limitations.

  We’ve encountered many of those limitations in Chapter 2. Two additional aspects of the lizard brain are harmful to investing success. The first is our desire to conform, and the second is the fact that our emotions really do seem to be out of sync with financial markets—both of which tend to lose us money.