Continuing our chapter-by-chapter review of "The Investor's Manifesto," by William J. Bernstein, we're going to look at Chapter 4, which focuses on investor behavior. In the last chapter we made a plan for how to handle our portfolio. In this chapter, we learn why many investors don't stick to their plans, to their detriment.
This chapter could be subtitled "All the ways you're going to shoot yourself in the foot." To me, it's one of the least-interesting chapters in the book. But it's certainly important to realize all the ways you can sabotage yourself, and the importance of not doing so.
We Crave Easy-to-Understand Narratives
We see a pattern and create a narrative ourselves to explain it, or hear a narrative and use it to explain the circumstances we see in the market. The problem is that an easy-to-understand narrative is often completely false, and, even if true, is often only a small part of the truth.
Today’s narrative is all too apparent: “The world economy is imploding, and corporate profits will collapse along with it. Stocks will become worthless.” Yet, the Gordon Equation computation of expected returns shown in Chapter 1 clearly shows that even if earnings disappear for a few years, future equity returns should be reasonable, particularly for REITs and foreign stocks. Similarly, bonds of all stripes—except everybody’s current favorite, Treasury securities—should also do just fine, as long as the investor keeps maturities relatively short (less than five years) to mitigate the risk of unexpected high inflation. Learn to automatically mistrust simple narrative explanations of complex economic or financial events.
By contrast, a mere decade ago the prevalent narrative was far more upbeat: “The Internet changes everything.” This exciting new technology was going to drive our economy, corporate profits, and stock prices into the stratosphere, and we were all going to get rich. The only problem was that when economists looked for hard evidence of this miracle in the macroeconomic data, it just was not there.
Popular finance books provide an excellent barometer of uninformed narrative-borne public sentiment, since ambitious financial authors tend to pander to it. One group of researchers indeed found that when the bookshelves turn bearish (The Crash of 1979, published in 1976, and The Great Depression of 1990, published in 1985), stocks had above-average future returns. The opposite happened when bullish titles (most infamously, the already-mentioned Dow 36,000, published near the peak of the 1999 bubble) lined the shelves.
We Want to Be Entertained
Apple is an exciting stock to own (if you like Apple products). So are Google, Facebook, and other technology companies if you're a geek like me. If you're wired differently, maybe Whole Foods is exciting. Initial Public Offerings (IPOs) are exciting.
General Electric is boring. Coca Cola is boring. Companies like this make us yawn.
That's what you want. There's an old Chinese curse that doesn't appear to be a curse until you think about it -- "May you live in interesting times." You don't want your investments to be exciting.
Thus, the more public visibility a company has, and the more well-known and entertaining its story, the lower its future returns are likely to be. By contrast, it is the most obscure companies in the most unglamorous businesses that often have the highest returns.
We Are Too Easily Frightened
Investing is an analytical game. If you want to be a winning investor, you carefully devise a plan, and you stick to it unless you decide that there was a flaw in the original plan.
Too often, bad results in the stock market scare us, and we pull our money out (selling at a loss). This is a time when we should actually be buying, but we aren't.
There's a Warren Buffett quote that epitomizes this:
Be Fearful When Others Are Greedy and Greedy When Others Are Fearful[1. I haven't been able to find this exact quote with attribution anywhere I trust. He's said many similar things, though, and if he hasn't said exactly this, he probably would.]
We Make Too Many Analogies
"This thing is like this other thing in one way, so it must be like it in other ways." We should strive to be driven by data, not by analogies.
"We should invest in really strong companies, because they will have strong stocks." No, actually weaker companies often have better returns.
"China has a rapidly growing economy, so we should invest there." No. Although China has had one of the world's highest economic growth rates, its stock market lost 3.3% per year between 1993 and 2008.
"The United Kingdom has sunk from being an empire to being a middle-weight European country. Avoid investing there." No. Actually, investors in the UK have done splendidly during the 20th century.
A Digression: Explaining Country by Country Returns
So why exactly do counties with good economies tend to have bad stock markets, and vice versa? Bernstein has an explanation:
Glamorous countries that everyone wants to invest in don't need to provide strong returns to get investment. Stodgy, boring, slow-growing countries do need to do that.
Next Bernstein raises two points that don't seem directly on point to the good economy/bad stock question, but do explain why Asia has had bad returns:
Companies, like people, die and are replaced with new ones. In many foreign countries, particularly in Asia, the rate of new share issuance is especially high. This reduces per-share earnings and dividends, which in turn erodes overall stock returns.
Finally, in many developing markets, governments do not protect shareholders from the rapacity of management as well as in nations with more established legal systems. In other words, in these countries, management and controlling shareholders find it disturbingly easy to loot a company. Even more bluntly, a nation that does not protect its children from lead-contaminated toys will likely not protect its foreign shareholders.
We Extrapolate the Recent Past Too Far into the Future
If something has been happening, we think it will continue to happen. This is often the case, but it's wrong enough to make depending on it a very bad strategy for investing. Just because returns have been bad we think they'll continue to be bad -- when in fact, they'll revert to the mean. The same when returns have been good.
We Are All Better Than Average
AKA the Lake Wobegon conundrum. If you take a survey of American drivers, almost all will report that they're above average. Obviously, this is mathematically impossible. We all think we're better than we are.
This is why we encourage index investing -- better to avoid the decision than to bet your retirement on being better than everyone else.
We Need to Keep Up With the Joneses
If your investments are in safe and secure but not spectacular index funds, and your neighbor is getting spectacular results from his risky investments, you'll have a hard time sticking with your plan. But that's exactly what you should do.