bubble and subsequent collapse would likely have been much less violent. A similar reaction occurred in the United States in the wake of the 1929 crash that should give pause to many involved in the most recent speculative excess. At the center of this titanic story was a brilliant attorney of Sicilian origin, Ferdinand Pecora. Just before the market bottom in 1932, with embittered investors everywhere demanding investigation of Wall Street’s chicanery, the Senate authorized a Banking and Currency Committee. It promptly hired Pecora, then a New York City assistant district attorney, as its counsel. In the follow- ing year, he skillfully guided the committee, and via it the public, through an investigation of the sordid mass of manipulation and fraud that characterized the era. The high and mighty of Wall Street were politely but devastatingly interrogated by Pecora, right up to J.P. “Jack” Morgan, scion of the House of Morgan and a formidable figure in his own right. But the real drama centered around New York Stock Exchange President Richard Whitney. Tall, cool, and aristocratic, he symbolized the “Old Guard” at the stock exchange, who sought to keep it the pri- vate preserve of the member firms, free of government regulation. In the dramaof the October1929 crash, Whitney was theclosest thing Wall Street had to a popularhero. Atthe heightof the bloodshed on Black Thursday—October 25, 1929—hestrodet othe U.S. Steel post and madethe most famous singletrade in the historyof finance: a purchase of10,000 shares of U.S. Steel at 205, even though at that point it was trading well below that price. Thissingle-handedly stopped thepanic. But Dick Whitney was a flawed hero. His arrogance in front of the committee alienated both the legislators and the public. He was also a lousy investor, with a weakness for cockamamie schemes and an inability to cut his losses. He wound up deeply in debt and began bor- rowing heavily, first from his brother (a Morgan partner), then from the Morgan Bank itself, and finally from other banks, friends, and even casual acquaintances. In order to secure bank loans, he pledged bonds belonging to the exchange’s Gratuity Fund—its charity pool for employees. This final act would be his downfall. Under almost any other circumstances, he would not have been treated harshly for this transgression. But Whitney had found himself at the wrong place at the wrong time. In 1935, he went to Sing Sing. He was not the only titan of finance who found himself a guest of the state, however, and many of the most prominent players of the 1920s met even more ignominious ends. The moral for the actors in the recent Internet drama is obvious. When enough investors find themselves shorn, scapegoats will be 160 The Four Pillars of Investing sought. Minor offenses, which in normal times would not attract notice, suddenly acquire a much greater legal significance. The next Pecora Committee drama already seems to be shaping up in the form of congressional inquiries into the Enron disaster and brokerage ana- lyst recommendations. It is likely that we are just seeing the beginning of renewed government interest in the investment industry. On the positive side, four major pieces of legislation came out of the Pecora hearings. Unlike the post-bubble English experience, the com- mittee’s effect was positive; three new laws were introduced that still shape our modern market structure. The Securities Act of 1933 made the issuance of stocks and bonds a more open and fair process. The Securities Act of 1934 regulated stock and bond trading and estab- lished the SEC. The Investment Company Act of 1940, passed in reac- tion to the investment trust debacle, allowed the development of the modern mutual fund industry. And finally, the Glass-Steagall Act sep- arated commercial and investment banking. This last statute has recently been repealed. Sooner or later, we will likely painfully relearn the reasons for its passage almost seven decades ago. This legislative ensemble made the U.S. securities markets the most tightly regulated in the world. If you seek an area where rigorous gov- ernment oversight contributes to the public good, you need look no further. The result is the planet’s most transparent and equitable finan- cial markets. If there is one industry where the U.S. has lapped the field, it is financial services, for which we can thank Ferdinand Pecora and the rogues he pursued. How to Handle the Panic What is the investor to do during the inevitable crashes that charac- terize the capital markets? At a minimum, you should not panic and sell out—simply stand pat. You should have a firm asset allocation pol- icy in place. What separates the professional from the amateur are two things: First, the knowledge that brutal bear markets are a fact of life and that there is no way to avoid their effects. And second, that when times get tough, the former stays the course; the latter abandons the blueprints, or, more often than not, has no blueprints at all. In the book’s last section, we’ll talk about portfolio rebalancing—the process of maintaining a constant allocation; this is a technique which automatically commands you to sell when the market is euphoric and prices are high, and to buy when the market is morose and prices are low. Ideally, when prices fall dramatically, you should go even further and actually increase your percentage equity allocation, which would Bottoms: The Agony and the Opportunity 161 require buying yet more stocks. This requires nerves of steel and runs the risk that you may exhaust your cash long before the market final- ly touches bottom. I don’t recommend this course of action to all but the hardiest and experienced of souls. If you decide to go this route, you should increase your stock allocation only by very small amounts—say by 5% after a fall of 25% in prices—so as to avoid run- ning out of cash and risking complete demoralization in the event of a 1930s-style bear market. Bubbles and Busts: Summing Up In the last two chapters, I hope that I’ve accomplished four things. First, I hope I’ve told a good yarn. An appreciation of manias and crashes should be part of every educated person’s body of historical knowledge. It informs us, as almost no other subject can, about the psychology of peoples and nations. And most importantly, it is yet one more demonstration that there is really nothing new in this world. In the famous words of Alphonse Karr, Plus ça change, plus c’est la même chose: The more things change, the more they stay the same. Second, I hope I have shown you that from time to time, markets can indeed become either irrationally exuberant or morosely depressed. During the good times, it is important to remember that things can go to hell in a hand basket with brutal dispatch. And just as important, to remember in times of market pessimism that things almost always turn around. Third, it is fatuous to believe that the boom/bust cycle has been abolished. The market is no more capable of eliminating its extreme behavior than the tiger is of changing its stripes. As University of Chicago economics professor Dick Thaler points out, all finance is behavioral. Investors will forever be captives of the emotions and responses bred into their brains over the eons. As this book is being written, most readers should have no trouble believing that irrational exuberance happens. It is less obvious, but equally true, that the sort of pessimism seen in the markets 25 and 70 years ago is a near cer- tainty at some point in the future as well. And last, the most profitable thing we can learn from the history of booms and busts is that at times of great optimism, future returns are lowest; when things look bleakest, future returns are highest. Since risk and return are just different sides of the same coin, it cannot be any other way. 162 The Four Pillars of Investing P ILLAR T HREE The Psychology of Investing The Analyst’s Couch The biggest obstacle to your investment success is staring out at you from your mirror. Human nature overflows with behavioral traits that will rob you faster than an unlucky nighttime turn in Central Park. We discovered in Chapter 5 that raw brainpower alone is not suffi- cient for investment success, as demonstrated by Sir Isaac Newton, one of the most notable victims of the South Sea Bubble. We have no his- torical record of William Shakespeare’s investment returns, but I’m willing to bet that, given his keen eye for human foibles, his returns were far better than Sir Isaac’s. In Chapter 7, we identify the biggest culprits. I guarantee you’ll rec- ognize most of these as the face in the looking glass. In Chapter 8, we’ll devise strategies for dealing with them. This page intentionally left blank 7 Misbehavior The investor’s chief problem—and even his worst enemy—is likely to be himself. Benjamin Graham 165 Dick Thaler Misses a Basketball Game The major premise of economics is that investors are rational and will always behave in their own self-interest. There’s only one problem. It isn’t true. Investors, like everyone else, are most often the hapless cap- tives of human nature. As Benjamin Graham said, we are our own worst enemies. But until very recently, financial economists ignored the financial havoc wreaked by human beings on themselves. Thirty years ago, a young finance academic by the name of Richard Thaler and a friend were contemplating driving across Rochester, New York, in a blinding snowstorm to see a basketball game. They wisely elected not to. His companion remarked, “But if we had bought the tickets already, we’d go.” To which Thaler replied, “True—and inter- esting.” Interesting because according to economic theory, whether or not the tickets have already been purchased should not influence the decision to brave a snowstorm to see a ball game. Thaler began collecting such anomalies and nearly single-handedly founded the discipline of behavioral finance—the study of how human nature forces us to make irrational economic choices. (Conventional finance, on the other hand, assumes that investors make only rational choices.) Thaler has even extended his research to basketball itself. Why, he wonders, do players usually go for the two-point shot when down by two points with seconds remaining? The two-point percent- age is about 50%, meaning that your chance of winning is only 25%, since making the goal only serves to throw the game into overtime. A three-point shot wins the game and has a better success rate—about 33%. At about the same time in the early 1970s that Thaler and his friend were deciding whether or not to brave the snowstorm, two Israeli psy- chologists, Daniel Kahneman and Amos Tversky, were studying the imperfections in the human decision-making process in a far sunnier clime. They published a landmark paper in the prestigious journal Science, in which they outlined the basic errors made by humans in estimating probabilities. A typical riddle: “Steve is very shy and with- drawn, invariably helpful, but with little interest in people, or in the world of reality . . .” Is he a librarian or mechanic? Most people would label him a librarian. Not so: there are far more mechanics than librar- ians in the world, and plenty of mechanics are shy. It is therefore more likely that Steve is a mechanic. But people inevitably get it wrong. The Kahneman-Tversky paper is a classic, but it is unfortunately couched in an increasingly complex series of mind-twisting examples. Its relevance to investing is not immediately obvious. But Thaler and his followers were able to extend Kahneman and Tversky’s work to economics, founding the field of behavioral finance. (Thaler himself dislikes the label. He asks, “Is there any other kind of finance?”) This chapter will describe the most costly investment behaviors. It is likely that at one time or another, you have suffered from every single one. Don’t Get Trampled by the Herd Human beings are supremely social animals. We enjoy associating with others, and we particularly love sharing our common interests. In general, this is a good thing on multiple levels—economic, psycho- logical, educational, and political. But in investing, it’s downright dan- gerous. This is because our interests, beliefs, and behaviors are subject to fashion. How else can we explain why men wore their hair short in the 1950s and long in the 1970s? Why bomb shelters were all the rage in the early 1960s, then fell into disuse in later decades, when the number of thermonuclear weapons was exponentially greater? Why the pendulum between political liberalism and conservatism swings back and forth to the same kind of generational metronome as stocks and bonds? The problem is that stocks and bonds are not like hula hoops or beehive hairdos—they cannot be manufactured rapidly enough to keep up with demand—so their prices rise and fall with fashion. Think about what happens when everyone has decided that, as happened in the 1970s and 1990s, large growth companies like Disney, Microsoft, and Coca-Cola were the best companies to own. Their prices got bid 166 The Four Pillars of Investing to stratospheric levels, reducing their future return. This kind of price rise can go to absurd lengths before a few brave souls pull out their calculators, run the numbers, and inform the populace that the emper- or has no clothes. For this reason, the conventional investment wisdom is usually wrong. If everyone believes that stocks are the best investment, what that tells you is that everyone already owns them. This, in turn, means two things. First, that because everyone has bought them, prices are high and future returns, low. And second, and more important, that there is no one else left to buy these stocks. For it is only when there is an untapped reservoir of future buyers that prices can rise. Everyone Can’t Be Above Average In a piece on investor preconceptions in the September 14, 1998, issue of The Wall Street Journal, writer Greg Ip examined the change in investor attitudes following the market decline in the summer of 1998. He tabulated the change in investor expectations as follows: The first thing that leaps out of this table is that the average investor thinks that he will best the market by about 2%. While some investors may accomplish this, it is, of course, mathematically impossible for the average investor to do so. As we’ve already discussed, 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—people tend to be overcon- fident. Overconfidence likely has some survival advantage in a state of nature, but not in the world of finance. Consider the following: • In one study, 81%ofnewbusiness ownersthoughtthat they had a good chance of succeeding, but that only39%of their peers did. • In another study, 82% of young U.S. drivers considered them- selves in the top 30% of their group in terms of safety. (In self- doubting Sweden, not unsurprisingly, the percentage is lower.) The factors associated with overconfidence are intriguing. The more complex the task, the more inappropriately overconfident we are. Expected ReturnsJun. 1998 Sept. 1998 Next 12 months, own portfolio 15.20% 12.90% Next 12 months, market overall 13.40% 10.50% Misbehavior 167 “Calibration” of one’s efforts is also a factor. The longer the “feedback loop,” or the time-delay, between our actions and the results, the greater our overconfidence. For example, meteorologists, bridge play- ers, and emergency room physicians are generally well-calibrated because of the brief time span separating their actions and their results. Most investors are not. Overconfidence is probably the most important of financial behav- ioral errors, and it comes in different flavors. The first is the illusion that you can successfully pick stocks by following a few simple rules or subscribing to an advisory service such as Value Line. About once a week, someone emails me selection criteria for picking stocks, usu- ally involving industry leaders, P/E ratios, dividend yields, and/or earnings growth, which the sender is certain will provide market-beat- ing results. Right now, if I wanted to, with a few keystrokes I could screen a database of the more than 7,000 publicly traded U.S. companies according to hundreds of different characteristics, or even my own customized criteria. There are dozens of inexpensive, commercially available software programs capable of this, and they reside on the hard drives of hundreds of thousands of small and institutional investors, each and every one of whom is busily seeking market-beat- ing techniques. Do you really think that you’re smarter and faster than all of them? On top of that, there are tens of thousands of professional investors using the kind of software, hardware, data, technical support, and underlying research that you and I can only dream of. When you buy and sell stock, you’re most likely trading with them. You have as much chance of consistently beating these folks as you have of starting at wide receiver for the Broncos. The same goes for picking mutual funds. I hope that by now I’ve dissuaded you from believing that selecting funds on the basis of past performance is of any value. Picking mutual funds is a highly seduc- tive activity because it’s easy to find ones that have outperformed for several years or more by dumb luck alone. In a taxable account, this is especially devastating, because each time you switch ponies you take a capital gains haircut. There are some who believe that by using more qualitative criteria, such as through careful evaluation and interviewing of fund heads, they can select successful money managers. I recently heard from an advisor who explained to me how, by interviewing dozens of fund managers yearly and going to Berkshire shareholder meetings to listen to Warren Buffet, he was able to outperform the market for both domestic and foreign stocks. The only problem was that his bond, real 168 The Four Pillars of Investing estate, and commodities managers were so bad that his overall port- folio results were far below that of an indexed approach. Take anoth- er close look at Figure 3-4. If the nation’s largest pension plans, each managing tens of billions of dollars, can’t pick successful money man- agers, what chance do you think you have? Most investors also believe that they can time the market, or worse, that by listening to the right guru, they will be able to. I have a fanta- sy in which one morning I slip into the Manhattan headquarters of the major brokerage firms and drop truth serum into their drinking water. That day, on news programs all over the country, dozens of analysts and market strategists, when asked for their prediction of market direc- tion, answer, “How the hell should I know? I learned long ago that my predictions weren’t worth a darn; you know this as well as I. The only reason that we’re both here doing this is because we have mouths to feed, and there are still chumps who will swallow this stuff!” Atanyone moment, bysheerluck alone, there will beseveral strategists and fund managers who will be righton the money. In 1987, it was ElaineGarzarelli who successfullypredicted thecrash. Articulate, well-dressed,and flamboyant, she got farmore media attention than she deserved. Needless to say, this was the kiss of death.Her predictive accuracy soon plummeted. Adding insultto injury, herbrokerage house put herinchargeof a high-profile fund that subsequentlyperformed so badlythat it was quietly killed off sev- eral years later. The most recent guru-of-the-monthwas Abby Joseph Cohen, who is low-key, self-effacing,and, for a market strategist, fairlyscholarly. (Her employer,Goldman Sachs, which emergedf rom the depthsof ignominy in 1929 to becomethe most respectedname in investment banking, makes a habitof hiring onlythose withdazzling math skills.)From 1995to1999,she was in the market’ssweet spot, rec- ommending a diet high in big growth and tech companies. Unfortunately, she didn’t see the bubblethat was obvious to most other observers, and for the past two years, she’s been picking the egg off herface. Remember, even a stopped clock is right twice a day. And there are plenty of stopped clocks in Wall Street’s canyons; some of them will always have just shot a spectacular bull’s-eye purely by accident. There are really two behavioral errors operating in the overconfi- dence playground. The first is the “compartmentalization” of success and failure. We tend to remember those activities, or areas of our port- folios, in which we succeeded and forget about those areas where we didn’t, as did the advisor I mentioned above. The second is that it’s far more agreeable to ascribe success to skill than to luck. Misbehavior 169 [...]... or a few stocks and forgotten about On the other hand, the high-net-worth client is the ultimate brokerage firm cash cow and is likely to be traded in and out of an expensive array of annuities, private managers, and limited partnerships The wealthy are different than you and I: they have many more ways of having their wealth stripped away Summing It Up In the words of Walt Kelly, “We have met the. .. Thaler protégé Russell Fuller and his colleagues looked at the popular growth stocks the top fifth of the market in terms of their P/E ratio Their data showed that these very expensive companies increased their earnings about 10% faster than the market in year one, 3% faster in year two, 2% faster in years three and four, and about 1% faster in years five and six After that, their growth was the same... highly abstract patterns Newton’s intuition of the gravitational equation from a falling apple and Darwin’s extrapolating the theory of evolution from observing gardeners and farmers select for favorable plant characteristics are two spectacular examples of this ability We all rely on pattern recognition in our everyday lives, from complex professional tasks down to things as mundane as the route we take... financial page of most newspapers printed a plot of the pre-crash stock rise and fall in the 1925–1933 period, superimposed with that of the 1982–1987 period The implication was that, since the plots matched so closely before both crashes, a further catastrophic fall in stock prices similar to that of 1929–1933 was all but certain For a whole host of reasons, starting with the fact that the Fed managed...170 The Four Pillars of Investing The Immediate Past Is Out to Get You The next major error that investors make is the assumption that the immediate past is predictive of the long-term future Take a look at the data from the table at the beginning of the chapter and note that in September 1998, after prices had fallen by a considerable amount, investors’ estimates of stock returns were lower than they... hillside This page intentionally left blank 8 Behavioral Therapy In the last chapter, we examined the many sins to which the frail investment flesh is heir In the next pages, we’ll formulate strategies for defeating the enemy in the mirror As always, the execution is a good deal harder than the planning, since we are attempting to vanquish some of the most primeval forces of human nature In most cases, this... that too many people have already invested in it This was true of real estate and gold in the early 1980s, Japanese stocks in the late 1980s, the Tiger nations in the early 1990s, and most recently, technology companies in the late 1990s In each case, disaster followed So when all your friends are investing in a certain area, when the business pages are full of stories about a particular company, and... $179,623.” When you take risk, you should be earning a “risk premium,” that is, an extra return for bearing the ups and downs of the market Or you can turn the risk premium around and call it a “safety penalty,” the amount of return you lose each year when you avoid risk Let’s be on the conservative side and assume that the safety penalty is just 3% per year That means that for each dollar you make by investing... is that company glamour is even more ephemeral A glamorous company is one with strong growth, usually selling at a very high multiple of earnings For example, at the height of the market froth in the spring of 2000, the three companies mentioned in the last paragraph sold at 48, 84, and 67 times earnings, respectively—from three to four times the valuation of a typical company This means the market... resources at their command that are simply out of your league Do you think that you can successfully pick market-beating fund managers? I hope that the data in Chapter 3 on fund performance has convinced you otherwise If you actually were able to do so, then you would have a lucrative career as a pension fund consultant ahead of you, since the nation’s largest corporations would pay you handsomely . you really think that you’re smarter and faster than all of them? On top of that, there are tens of thousands of professional investors using the kind of software, hardware, data, technical support,. crashes, a further catastrophic fall in stock prices similar to that of 1929–1933 was all but certain. For a whole host of reasons, starting with the fact that the Fed man- aged the 1 987 crash. error that investors make is the assumption that the immediate past is predictive of the long-term future. Take a look at the data from the table at the beginning of the chapter and note that in September