SOME THINGS SEEMED clear as I wrote this introduction in late August 2011. Although we have recently survived the worst economic and market period since the Great Depression, we are on anything but a solid footing today. Many market experts call the 2000–2009 period the “lost decade.” People lost heavily in the dot-com crash of 2000–2002 and even more in the subprime crash of 2007–2008, which not only dented their remaining savings but also substantially knocked down the prices of their homes. So much for the idea that modern investment methods and critical information delivered in nanoseconds would make this nearly impossible.
By June 2011, stock prices doubled from their lows of March 2009. But it wasn’t to last. After moving to its high of up 111 percent from the March 2009 low, the market took one of its sharpest dives in decades. From the July high through late September, the S&P 500 index free-fell almost 20 percent, a drop that cost investors more than three trillion dollars. The plunge was considered by many senior money managers to be the beginning of a new bear market as business activity concomitantly slowed dramatically. From almost universal investor agreement that the world economies and markets were improving, fears built up rapidly that we were entering a new recession. Most investors were bewildered and a good number were terrified. Who could blame them? Along with a frightening drop in prices reminiscent of September to December of 2008, volatility, exceptionally low for eighteen months, skyrocketed in four days in August 2011; the Dow Jones Industrial Average dropped 635 points, then rose 430 points, then dropped 520 points, and finally rose 423 points.
The result was confusion and panic rarely seen. Fearing a sharp recession, both Americans and foreigners poured into U.S. Treasuries even though they had been downgraded by Standard and Poor’s, one of the nation’s foremost credit-rating agencies, for the first time in U.S. history. Nevertheless investors rushed into them and into gold, which they regarded as the only secure investments available. Treasuries shot up a remarkable 15 percent from the beginning of the July 2011 stock market decline.
Hundreds of thousands of other investors bought gold, and in six months it rocketed from $1,400 to $1,900. Buying Treasuries because it was believed we were on the cusp of a major recession and buying gold because runaway inflation was expected in a highly overheated economy were diametrically opposite investor reactions to the same market events. It was like betting heavily on a horse to both win and come in trailing the pack in a major race. The investor, like the bettor in the analogy of the race, is almost destined to lose either way, because the house keeps a healthy percentage of both bets.
To further complicate recent developments, the over-two-month battle in July–August of 2011 to raise the U.S. debt limit, thereby preventing a U.S. default, which went down to the wire, shook the confidence of many large foreign investors in Treasuries from Russia to China to Japan, and again injected major fear into U.S. markets. The debt freeze has been estimated to eventually cost over one million domestic jobs, because state and municipal governments cannot get the money from the federal government to finance road and highway construction, maintenance, and other badly needed infrastructure projects. Our politicians certainly are far from winning public accolades for their performance. Recent public opinion polls have shown approval for congressional actions in the 20 percent range. Unfortunately the negativity does not stop there.
Many people of all political persuasions have serious questions about the quality of our economic leadership, at both the Treasury and the “independent” Federal Reserve—a concern that now stretches from the Clinton years through the Bush presidencies and the first two and a half years of the Obama administration—as well as a deep distrust of the investment bankers and banks who together came close to wiping out both our own and the global financial system in 2007 and 2008.*1 The Federal Reserve, for example, quietly loaned the biggest problematical banks 1.2 trillion dollars in 2008. Almost half of the largest borrowers were foreign banks. These loans were about the same amount as U.S. mortgage borrowers currently owe on 6.5 million delinquent and foreclosed mortgages.1 The delinquent mortgage holders naturally received nothing, while many officers of the biggest troubled banks received mind-boggling bonuses and severance payments.
So where do markets and the economy stand today? The truth is that nobody knows. Horrible exogenous events can tempt you to give up your faith in the bullish case for stocks. Who could foresee the earthquake in Japan in March 2011 measuring 9.0 on the Richter scale or the giant tsunami that followed only minutes later, which created enormous devastation as well as taking thousands of lives? Those were followed within days by four adjacent nuclear plants of the Tokyo Electric Power Company being on the verge of a meltdown that threatened to take many thousands of additional lives and send markets worldwide plummeting because of the fear that this disaster would thwart global economic growth for years.
Small wonder that many people worry that even fiercer winds are not far off, while others, like myself, think the great storm is almost over and markets will continue to move higher over time, albeit with a full complement of bone-jarring such as we have just seen. One thing, though, is certain: the times are very different today from a little over a decade ago. All the investment standards we were comfortable with for many years appear to have fallen by the wayside. Many of today’s financial teachings are actually toxic to your portfolio. For many generations, investors kept their money in bonds and believed they were investing prudently. Doing so today would bring about disaster. Treasury bills, supposedly the safest investment there is, have cost investors 77 percent of their purchasing power since 1946.
Can we depend on savvy and knowledgeable money managers to get us out of this quandary? No, that won’t work either. They consistently underperform the market over time. John Bogle, the ex-chairman of the Vanguard Group of Mutual Funds, is an expert on mutual fund performance. Bogle heads Financial Markets Research Center, which showed that between 1970 and 2005, a period of thirty-six years, only 2.5 percent of the 355 equity mutual funds in existence in 1970 outperformed the S&P 500 by at least 2 percent. A whopping 87 percent of the funds either didn’t survive or underperformed the market.2
Then what are we left with? Once again, as Plato noted more than 2,400 years ago, necessity will prove to be the mother of invention. The sky is not falling; there will be some excellent opportunities ahead for those who are not fixated on the past. I’m convinced that the country is strong enough to put the last decade’s devastating crashes behind it. It is obvious that the mistakes and incompetence of the policy makers and the level of greed that caused the subprime collapse cannot be brushed aside and soon forgotten, but in this book we are concerned primarily with how to rebuild your savings, how to structure your portfolio to withstand likely conditions ahead, and how to take the proper actions that will let your portfolio prosper again over time.
That is a tall order, requiring us to reexamine and fundamentally challenge the investment theory most of us have used for generations. We must keep what is useful but discard what doesn’t work, basing this decision not on anecdotal reports but on solid empirical performance data. It is, however, admittedly not a walk in the park.
In the opening chapters of this book, I will make the case that not only the recent crashes but a host of powerful research findings to be introduced have definitively proven that the efficient-market hypothesis (EMH), the reigning investment paradigm, which states that sophisticated investors always keep prices where they should be, is incapable of providing accurate explanations of why current investment theory has failed, often miserably. Its basic assumptions are going to be thoroughly analyzed, and as we analyze them, we’ll see how they have been clearly refuted. The error at the heart of EMH, we will see, is that it simply does not recognize that psychology plays a part in your investment decisions. The efficient-market theorists—and most economists—do not believe that psychology, with its “softening” of human rationality, should be allowed a role in investment or economic decision making. Instead, it seems, they have plastered the lipstick of complex mathematics onto an academically abstract piggy to sell a lot of theoretical bacon. The deceit is certainly not intentional; the theory’s supporters believe it, despite numerous refutations of many of its premises. Science has always had a fair share of such sincere but mistaken researchers who simply won’t give up on a cherished theory. In an important sense the book is a new investment paradigm or method of investing. A new paradigm is normally accepted only when an old one can no longer explain events heretofore believed to be fully explicated by it. We are at just such a crossroads today.
Appreciating the fundamental flaws in the investment strategies based on EMH will demand that we take a close look at one of the major sources of investment errors—the person you see in the mirror every morning. What psychology has to tell us about our investing behavior as individuals and within groups is, I think you will come to agree, both eye-opening and surprisingly useful in crafting an optimal investing strategy. Introducing a set of powerful psychological insights that help explain why investors so often make incorrect decisions and why the market is subject to so many booms and busts, it will provide ways to help us reject the siren call of many failed methods that are still the mainstay of contemporary investment practices; it will enable you to become a psychological investor. You will start looking at the “wacky” world of investing through a new sort of glasses: contrarian psychological shades (patent pending).
Program for This BookI think readers would like to know at this point, in case you’re faintly worried, that a dry academic debate or dull scholarly treatise is not on tap. You can relax. I will present the research findings in an easily understandable manner, not with complicated mathematical equations.
As you may already have noted, there are five parts in this book, each covering a major thematic area. Part I, “What State-of-the-Art Psychology Shows Us” looks at some of the most bizarre investment manias in history, crises that have helped us develop the new psychological insights into investors’ behavior. From sophisticated French nobles in the early eighteenth century to contemporary investment bankers (circa 2006) wearing sleek Zegna suits, nothing has held back people who believe that enormous wealth is within their grasp. Yet fascinating as these stories are, our purpose here is very different. We want to see how a historical perspective can be transformed into a psychological one that might be predictive of the characteristics of future bubbles and allow us to avoid jumping on the next bandwagon.
Readers already conversant with psychology and stock market interactions will find some familiar themes and alarm bells in this work. But what is decidedly new for everyone is some recent psychological research that has pushed our understanding of investment strategies light-years ahead. Two new topics, Affect theory and neuroeconomics, are especially exciting to researchers, and neither has yet to be absorbed into Wall Street’s conceptual tool kit.
The finding of how what is known as Affect works provides us with a powerful understanding of how people can so often be caught up in bubbles and come out almost penniless when they are over. Affect also works against investors in far more normal market conditions. We’ll examine its influence, how it was discovered through psychological research, and the role that its various corollaries have played in distorting “rational” market behavior.
Then we’ll take up a number of other psychological pitfalls that are waiting to snare the unwary investor. It turns out, for example, that people simply aren’t very good statistical information processors, and that this deficiency leads them to make consistent and predictable investment errors. We’ll also discover that the more we like an investment, the less risk we think it entails even if it is riddled with risk, and that in some well-known scenarios we consistently misplay odds when they are heavily against us. We’ll also see how some aspects of psychology can continually trick us into buying securities that are red-hot just before they collapse and why so many of us continually play against bad odds.
We’ll conclude by introducing two more heuristics (mental shortcuts), representativeness and availability, that cause systematic errors in our judgment. Both consistently take a good slice out of most investors’ portfolios. Throughout, we will see how psychologically compelling these mental shortcuts are and how hardwired into our minds they happen to be. But by learning to recognize them in action, we can fend off their all-too-tight mental embrace.
In Part II, “The New Dark Ages,” a critical review of the efficient-market hypothesis will help you develop a precise understanding of why the most recent market crashes have proved so destructive and why the latest one has lasted so long.
We will also deal with the efficient market’s sidekick, risk analysis. It states that if you want higher return, you must take higher risk, defined as volatility. Less volatility will give you lower returns. Yet this essential portfolio protection, which you’ve been told for years would keep your savings secure, doesn’t work and never did. We will also see that the risk evaluation methods employed today have failed miserably. The theory of risk that investors have depended on for decades to protect their portfolios is constructed on specious reasoning. Today we do not have a workable theory of risk to defend ourselves, nor have we had one in close to forty years. Small wonder that performance results have been so disappointing when bear markets come along. As will be detailed, this risk theory has been the chief culprit in the three shattering crashes since 1987 alone. We’ll see why and look at something better, a new, workable theory of risk, which is well documented and will take in many of the important risk factors we are faced with today, as well as some new and potentially devastating ones that are not yet incorporated into investment teachings.
Along the way there are some hard lessons to be learned. For example, liquidity was completely sucked out of the system in 2008 and has only partially returned. We know that 60 percent of new jobs in the United States are created by companies with one hundred or fewer employees. Yet the banks, in spite of trillions of taxpayer dollars directly (and indirectly) funneled their way, have refused to lend to these job-creating firms. They couldn’t, as far too much of their excess capital was invested in illiquid subprime mortgages. And guess what academic thinking encouraged them to have such small liquidity reserves? Yes, the efficient-market theorists strike again.
We’ll wrap up this section with a humorous but far too precise comparison of EMH to the ancient Ptolemaic theory of planetary motions, with efficient-market advocates playing the role of ancient astronomers loudly insisting, with lots of equations and highly advanced mathematics, that the sun absolutely has to orbit around the earth. There could be no other way.
Part III, “Flawed Forecasting and Poor Investment Returns,” shows that despite the great confidence in forecasting, analysts’ forecasts through the years have been remarkably off the mark. Today’s analysts are expected to fine-tune earnings estimates within 3 percent of actual reported earnings to prevent damaging earnings torpedoes after an earnings surprise. The evidence in these chapters of large groups of analysts’ estimates over forty years demonstrates that earnings surprises are many times higher than the 3 percent analysts believe will not disrupt markets and are remarkably frequent.
Further evidence indicates that even the smallest earnings surprise can have a major effect on stock prices. Most important, the research strongly demonstrates that surprises benefit contrarian stocks and damage favorite stocks over time, providing strong new evidence supporting the use of contrarian strategies. Despite the robustness of these findings, analysts and money managers ignore them. We must not make the same mistake.
In Part IV, “Market Overreaction; The New Investment Paradigm,” I introduce the contrarian strategies that will allow you to account for these psychological foibles and forecasting errors, showing that these strategies have stood the test of time and also did well through the “lost decade” and the first ten years of the twenty-first century, outperforming the market and “favorite” stocks. (The returns, though positive, were naturally lower, given the two severe crashes during this time; but there was no total devastation or major loss of capital, as so many experienced.) When the bear roared loudly, the contrarian investors could stay the course with considerable confidence. We will take a close look, in particular, at how they fared through the dot-com bubble of 1996–2000 and the financial crisis of 2007–2008. The book will also fine-tune the strategies in light of the 2007–2008 crash by adding some further investment guidelines and safety features.
A powerful hypothesis of investor behavior will also be presented, which explains why and how investors so often misvalue investments. It is called the investor overreaction hypothesis (IOH), and its thesis is that investors almost constantly overpay for stocks they like and just as consistently underpay for stocks they don’t. The IOH so far has twelve testable points, with more likely to be added as research continues.
Part V, “The Challenges and Opportunities Ahead,” looks at what we should expect from markets in the next few years. We’ll also discuss the tools investors will need to handle the high-probability scenarios that will be described.
Our tour d’horizon of this brave new financial world will touch on what is likely to come. We may be saying farewell to the “Great Recession,” but investors are a long way from exiting the perilous woods of inflation. As a forward-looking investor, you’ll want to be fully equipped and knowledgeable about the critical financial issues that could engulf us at practically any point in the future.
The most important scenario is the major likelihood of serious inflation within two to five years, not only in the United States but also globally. We’ll consider the best investments that are likely to preserve your capital and even flourish in an inflationary environment. Also, we’ll review methods that investors in many other countries that have faced similar inflationary challenges have successfully followed to survive and prosper.
A Personal NoteYou’re going to run across an occasional brief note on my private or professional experiences. Some of these notes I hope are amusing, and some are moments I’d definitely prefer not to repeat. I thought that in a work that’s so heavily indebted to the discipline of psychology, these personal reminiscences would lightly remind us that in the end we’re all only human.
Sure, I’ve made more than a few investing choices I’d do over, and certainly not every single stock I’ve picked has come up a winner. I’ve had a few squirmy reminders that psychology affects me as much as the next guy. But as Warren Buffett once said, if a manager can bat .600 over time—get a hit six times out of ten—he or she will prove to be a big winner. In the end, fortunately, I was one of the few who outperformed the market over an extensive period of time.
Ultimately, the most essential thing you can take away from the entire book is this: the psychology-aware investor holds a superior advantage, not just more theoretical knowledge but a genuine practical investing edge. I hope that’s an appealing reason to read on.
Inevitably, not all market analysts will agree with my analysis. New ideas, even when they are strongly backed by empirical investment and psychological research, will not be accepted by most, because they contradict and threaten to dethrone the theory of the day. It doesn’t matter how good the new work proves to be or how badly the reigning ideas have failed; that’s irrelevant to the true believers, who will try to hold their turf to the last dollar that you have. That’s the way of paradigm change and probably has been since time immemorial. But fortunately the attacks are never on the reader; it’s the writer who is always called out.
I have fielded criticism from academic and professional experts for more than thirty years, some of it containing sharp personal attacks. Nevertheless, though the fusillades may have sent a few of my feathers flying—not to mention on occasion raising my blood pressure to a frothy level—they have never been able to undermine the work.
I believe that it is vital that we never underestimate the role psychology plays in the market. It can be our best friend if we follow the proven contrarian strategies that protect us so well against psychological traps. It can also be our worst enemy if we try to outguess the traps, for example, saying something like, “Okay, this market will blow, but I’ll just stay in a teeny bit longer” or “Heck, I’ve got my ten-bagger, I’ll sell at eleven.” Chances are those portfolios will end up at or near another financial Boot Hill. Psychology, no matter how much you’ve studied it or think you know it, can reduce both your ego and your net worth very quickly.
David Dreman
Aspen, Colorado
September 30, 2011