Behavioral economics says we can beat the market

Misbehaving: The Making of Behavioral Economics, by Richard Thaler, is an interesting history of this new-ish subfield from the inside. It also contains some potentially useful guidance for investors!

Thaler points out that the rational beings on which the theories of Econ 101 rest do not exist in the real world. None of us make rational purchase decisions, for example. Aggregating a huge group of irrational people does not make our decisions somehow more rational:

the premises on which economic theory rests are flawed. First, the optimization problems that ordinary people confront are often too hard for them to solve, or even come close to solving. Even a trip to a decent-sized grocery store offers a shopper millions of combinations of items that are within the family’s budget. Does the family really choose the best one? And, of course, we face many much harder problems than a trip to the store, such as choosing a career, mortgage, or spouse. Given the failure rates we observe in all of these domains, it would be hard to defend the view that all such choices are optimal.

The book contains a good introduction to all of the big issues in behavioral economics, e.g., that people are loss-averse and also that they demand fairness (which is why we must all vote a Warren-Sanders ticket for president!).

Perceptions of fairness also help explain a long-standing puzzle in economics: in recessions, why don’t wages fall enough to keep everyone employed? In a land of Econs, when the economy goes into a recession and firms face a drop in the demand for their goods and services, their first reaction would not be to simply lay off employees. The theory of equilibrium says that when the demand for something falls, in this case labor, prices should also fall enough for supply to equal demand. So we would expect to see that firms would reduce wages when the economy tanks, allowing them to also cut the price of their products and still make a profit. But this is not what we see: wages and salaries appear to be sticky. When a recession hits, either wages do not fall at all or they fall too little to keep everyone employed. Why? One partial explanation for this fact is that cutting wages makes workers so angry that firms find it better to keep pay levels fixed and just lay off surplus employees (who are then not around to complain). It turns out, however, that with the help of some inflation, it is possible to reduce “real” wages (that is, adjusted for inflation) with much less pushback from workers.

Speaking of fairness, note that Uber has eliminated its “surge pricing” annotation. When the price is higher than usual, customers see a higher quoted price, not a screaming “surge pricing” banner. Restaurants and theaters would rather have a long waiting list than charge a market-clearing price. A chef is quoted as saying that he didn’t want to charge so much that customers would leave feeling that they’d been overcharged.

Stock markets are irrational and predictably irrational as far as Thaler and colleagues are concerned. Companies shouldn’t pay taxable dividends, for example, when they can buy back shares and compensate investors with a higher stock price:

Shefrin and Statman’s answer relied on a combination of self-control and mental accounting. The notion was that some shareholders—retirees, for instance—like the idea of getting inflows that are mentally categorized as “income” so that they don’t feel bad spending that money to live on. In a rational world, this makes no sense. A retired Econ could buy shares in companies that do not pay dividends, sell off a portion of his stock holdings periodically, and live off of those proceeds while paying less in taxes. But there is a long-standing notion that it is prudent to spend the income and leave the principal alone, and this idea was particularly prevalent in the generation of retirees around in 1985, all of whom had lived through the Great Depression.*

Gambling on the ponies is irrational. Betting on the even-money favorite will return 90 cents on the dollar. Betting on the longshot will return 14 cents and the returns get worse at the end of the day. Surely professionals investors are not as dumb as folks who gamble at the track? Thaler summarizes research suggesting that investors are actually just as dumb!

Thaler says that the equity premium (excess returns of stocks compared to bonds) is higher than it should be, even after economists pointed out that the equity premium is too high. The idea that professional investors are irrational is an old one, going back at least to Keynes:

Keynes thought markets were more “efficient,” to use the modern word, in an earlier period at the beginning of the twentieth century when managers owned most of the shares in a company and knew what the company was worth. He believed that as shares became more widely dispersed, “the element of real knowledge in the valuation of investments by those who own them or contemplate purchasing them . . . seriously declined.” … Keynes was also skeptical that professional money managers would serve the role of the “smart money” that EMH defenders rely upon to keep markets efficient. Rather, he thought that the pros were more likely to ride a wave of irrational exuberance than to fight it. One reason is that it is risky to be a contrarian. “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

The simple “value investing” idea put forward by Benjamin Graham, i.e., buy stocks with a low P/E ratio, continued to work 50 years after its conception:

It was not so much that anyone had refuted Graham’s claim that value investing worked; it was more that the efficient market theory of the 1970s said that value investing couldn’t work. But it did. Late that decade, accounting professor Sanjoy Basu published a thoroughly competent study of value investing that fully supported Graham’s strategy. However, in order to get such papers published at the time, one had to offer abject apologies for the results. Here is how Basu ended his paper: “In conclusion, the behavior of security prices over the fourteen-year period studied is, perhaps, not completely described by the efficient market hypothesis.”

Both the best companies and the worst tend to revert to the mean:

Finding evidence of mean reversion would constitute a clear violation of the EMH. So we decided to see if we could find that evidence. Our study was simple. We would take all the stocks listed on the New York Stock Exchange (which, at that time, had nearly all of the largest companies) and rank their performance over some time period long enough to allow investors to get overly optimistic or pessimistic about some company, say three to five years. We would call the best performing stocks “Winners” and the worst performers “Losers.” Then we would take a group of the biggest Winners and Losers (say the most extreme thirty-five stocks) and compare their performance going forward. If markets were efficient, we should expect the two portfolios to do equally well. After all, according to the EMH, the past cannot predict the future. But if our overreaction hypothesis were correct, Losers would outperform Winners. Such a finding would accomplish two things. First, we would have used psychology to predict a new anomaly. Second, we would be offering support for what we called “generalized overreaction.” Unlike the Kahneman and Tversky experiment in which subjects were overreacting to measures of sense of humor when predicting GPA, we were not specifying what investors were overreacting to. We were just assuming that by driving the price of some stock up or down enough to make it one of the biggest winners or losers over a period of several years, investors were likely to be overreacting to something. The results strongly supported our hypothesis. We tested for overreaction in various ways, but as long as the period we looked back at to create the portfolios was long enough, say three years, then the Loser portfolio did better than the Winner portfolio. Much better. For example, in one test we used five years of performance to form the Winner and Loser portfolios and then calculated the returns of each portfolio over the following five years, compared to the overall market. Over the five-year period after we formed our portfolios, the Losers outperformed the market by about 30% while the Winners did worse than the market by about 10%.

Can the non-behavioral economists fix this? No! says Thaler.

The efficient market hypothesis could be reconciled with our results if the Loser stocks had high betas and thus were risky according to the CAPM, and the Winner stocks had low betas, meaning they were less risky. … By whatever measure one used, “value stocks” outperformed “growth stocks,” and to the consternation of EMH advocates, the value stocks were also less risky, as measured by beta.

The practical advice from the book is to buy value stocks and small cap stocks. A portfolio of “blue chip” large cap stocks would be almost certain to underperform in the long run (see GE!).

Can we get good advice for day-to-day trades from economists? Nobel laureate Paul Krugman predicted a dramatic and persistent stock market depression after the Trumpenfuhrer was sent to the Reichstag in November 2016. Nobel laureate Bob Shiller predicted a stock market crash in 1996, according to Thaler. The S&P 500 was 1,050 when they sounded the doom horn. The stock market did crash starting in 2000. It fell from 2,100… to about 1,150. In other words, if you’d gone short in 1996 and then perfectly timed the bottom of the stock market in 2002 you still would have lost money (plus another 3 percent per year in dividends that you’d have had to pay out). Thaler credits Shiller with prescience and says he was too early, but does not point out that Shiller was actually wrong based on the numbers.

Real estate seems to be one of the most irrational of all markets.

My conclusion: the price is often wrong, and sometimes very wrong. Furthermore, when prices diverge from fundamental value by such wide margins, the misallocation of resources can be quite big. For example, in the United States, where home prices were rising at a national level, some regions experienced especially rapid price increases and historically high price-to-rental ratios. Had both homeowners and lenders been Econs, they would have noticed these warning signals and realized that a fall in home prices was becoming increasingly likely. Instead, surveys by Shiller showed that these were the regions in which expectations about the future appreciation of home prices were the most optimistic. Instead of expecting mean reversion, people were acting as if what goes up must go up even more. Moreover, rational lenders would have made the requirements for getting a mortgage stricter under such circumstances, but just the opposite happened. Mortgages were offered with little or no down payment required, and scant attention was paid to the creditworthiness of the borrowers. These “liar loans” fueled the booms, and policy-makers took no action to intervene.

In other words, it seems likely that the short trade that made John Paulson a multi-billionaire will work during the next bubble.

A fun corner of the book is a discussion of office allocation in a new building for the economists at University of Chicago:

Two other rules of interest: offices could not be traded and, after one senior faculty member inquired, the deans emphatically ruled out the possibility of buying an earlier draft pick from a colleague. This ruling, and the fact that the school decided not to simply auction off the draft picks, reveals that even at the University of Chicago Booth School of Business—where many favor an open market in babies and organs—some objects are simply too sacred to sell in the marketplace: faculty

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Financial Planning 101, v2.0

Dan had worked 80 hours per week in the family business since finishing high school. Due to the long hours, at age 45 he was still single and still living at home with his father.

His father’s health was failing, unfortunately, and it was clear that the man did not have long to live. Dan knew that he would inherit a fortune upon the death of his father and decided he needed to learn about investing.

One evening, at an meeting run by Morgan Stanley, the presenter asked attendees to talk about what they were hoping to get out of the seminar. Dan said “In a year or two, my father will succumb to his cancer and I will inherit roughly $200 million. I’d like to figure out if index funds are the best option or if, with this size portfolio, there are higher returns available from alternative investments, such as hedge funds and direct ownership of assets.”

Sitting next to him was a beautiful woman in her 20s. She complimented him on his taste in clothing and asked for his business card. Dan was flattered that a woman two decades younger would take an interest in him.

Three weeks later, she became his stepmother.


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Isn’t the Uber IPO guaranteed to be a scam?

“Uber Is Said to Aim for I.P.O. Valuation of Up to $100 Billion” (nytimes) says that the company wants to raise $10 billion via an IPO. Crunchbase says that the company has already raised $24 billion privately. In a world that is swimming in capital, why not just raise another $10 billion from private sources? Make one phone call to Goldman Sachs and say “I would like $10 billion please.”

Can there be a reason to go public other than getting “dumb money” to pay higher prices than what private equity and other professional investors would pay?

The same article notes that the investors who paid up for Lyft shares have already suffered a loss of 15 percent (as with most nytimes stories, this is fake news? Yahoo Finance shows a loss of 23 percent during a period in which the S&P 500 is up about 1.5 percent).

On the third hand, where are the likely competitors to Uber? From a technical point of view it would seem that Google and Apple would be the natural competitors. They have mapping software and know where both riders and drivers are. But if neither of those companies wants to enter the messy business in which customers may be injured or assaulted, then who could realistically compete?

I wonder if the Uber programmers are more capable than their counterparts at Google Maps. Uber is much smarter about predicting my likely destination than Google.

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Warren Buffett versus similarly leveraged S&P 500

From an email discussion group of hedge fund/bond fund managers….

I get the Financial Analyst’s Journal as part of my CFA registration. The attached article [“Demystifying Buffett’s Investment Success”] investigates the extent to which Berkshire Hathaway “beat the market”. It has significantly outperformed the S&P 500, especially before about 2000. Warren is called the “Oracle of Omaha”. This author finds that the return has been higher on his ownership of public companies (where he owns a stock we all could buy) than on the private companies. He concludes that this raises doubt that he has a superior management style and incentives. I am not sure I agree with that conclusion. He also said that BRK has debt, so you need to compare his return with a stock portfolio that is 170 percent of its equity, through leverage. That and a couple other factors pretty much explain his success. I guess that is good news, because it should be possible to keep it up when Warren eventually steps down.

In other words, the correct benchmark for Berkshire Hathaway is not the S&P 500, but rather a leveraged S&P 500 (since the trend for this index has been up, especially following the election of King Donald, the leveraged index outperforms the basic index).

Separately, is now a good time to buy Berkshire Hathaway? We’ve had some great years for the stock market so it seems as though the good times are due to end. Berkshire Hathaway was able to scoop up some great deals during the last panic (2008-2009).

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Time to buy foreign stocks and emerging markets in particular?

End-of-year portfolio rebalancing time.

What about this being the year of buying foreign stocks, especially emerging markets?

From a banker friend:

Since coming out of 2008/2009 the place to be has been US stocks, and more specifically US Large Cap growth stocks. On a relative basis US has outperformed International for something like 8 out of the last nine years. Last year, International and Emerging markets shined. That being said, if you look back to the period between around 1999 through 2007 International was the spot to be.

“Emerging Markets to US valuation ratio falls to its lowest since 2008” (October 2018; Economic Times (India)) suggests that emerging markets are a relative bargain. Bloomberg, July 2018:

Profits in developing countries rival those in the U.S. The EM index’s operating margin was 14.2 percent in the second quarter, compared with 13.8 percent for the S&P 500. Profit margins were also similar — 9.9 percent for the EM index compared with 9.5 percent for the S&P 500.

Yes, U.S. companies are generating a higher return on investment than those in emerging markets, but that’s only because U.S. firms are more levered. The EM index’s debt-to-equity ratio was 99 percent in the second quarter, compared with 113 percent for the S&P 500. After adjusting for leverage, the two indexes’ return on assets, return on equity and return on capital are all comparable.

The difference, however, is that emerging-market companies are far cheaper. The EM index’s price-to-earnings ratio is 13.3 based on 12-month trailing earnings per share, compared with 21.1 for the S&P 500. That difference is even more stark when looking beyond one year. The EM index’s P/E ratio is 14.7 based on 10-year trailing average EPS, compared with 29.5 for the S&P 500.

Is it reasonable to say that most of the good stuff that could happen to U.S. publicly-traded companies has already happened? They’ve had their tax rate cut from 40 percent (varies a bit by state) to around 25 percent. They’ve had interest rates set near zero for a decade. What else good can happen that isn’t already priced into current sky-high S&P 500 valuations?

(A lot of “U.S.” companies, of course, get the majority of their growth from foreign markets and some get the majority of their revenue from non-U.S. markets (see Apple, for example). So even if the U.S. stagnates (due to migrant caravans being stalled at the border?), some of these companies can still grow at the rate of world economic growth.)

A lot of bad stuff could yet happen to American companies. The festival of deficit spending could end and taxes raised so that we’re actually paying for all of the stuff that we demand from our Great Father in Washington. Regulations that favor trade unions could be imposed. Costs of defending employment lawsuits, including regarding #MeToo accusations, could increase.

So with limited upside and plenty of downside risk, why not sell U.S. stocks and buy foreign?

If buying foreign, why not go with the investments that have been out of favor, i.e., emerging markets? The Vanguard FTSE Emerging Markets ETF (VWO) tracks the “FTSE Emerging Markets All Cap China A Inclusion Index.” More than half of this index is China, Taiwan, and India. If you like to “buy on bad news,” you’ll be cheered to see 10 percent Brazil and South Africa in the index as well! (I’m hugely negative on South Africa’s economy; a growing population and fixed natural resources do not add up to a bright future as far as I can tell.)

Europe seems to be messed up, but maybe it would make sense to buy German and English stocks right now? The scary news about Brexit should already be priced into English currency and share prices. The news about Germany having been turned into a migrant camp should also already be priced in (and maybe it is bad news for Germans, who will be poorer per capita and suffer from more crowding and traffic jams, but is it bad for a Germany company?). I would be happy to buy Estonian securities. I have full confidence in that economy! (see What is there to buy, though? The whole country has half the population of metropolitan Boston.

Readers: What do you think? Sell some U.S. stuff as soon as there is euphoria from the Federal government being restored to full operation and buy emerging? The professionals seem to recommend roughly 45 percent non-U.S. holdings for long-term investors.

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Why the stock market keeps going up

Americans are out of work.  Factory orders are sluggish.  The economic news is grim yet the U.S. stock market keeps going up.  Can this be consistent?  Sure!  It is possible to believe simultaneously that the American people are getting poorer and that the largest American corporations are going to get ever richer.  How could this happen?  Group A and Group B can get richer if they work together to grow the pie.  Alternatively, Group B can get richer by transferring wealth from Group A.

We’ve discussed this already in this blog in the context of airline CEOs who managed to take $billions in taxpayer money and transfer quite a bit of it into their personal checking accounts as salaries, bonuses, guaranteed pensions, etc.  But there are more subtle ways in which corporations can acquire property formerly held by the public.

For example, movie studios (notably Disney) and other corporate copyright holders recently purchased a federal law that extended copyright out to 100 years (the Founders had it at 14; it was 75 years until recently).  There was no way for them to argue that this law would provide an incentive to authors because it applied to works that were created in the 1920s, i.e., whose authors had been dead for half a century or more.  The effect of this law was to transfer public average-Joe property (public-domain works) into the hands of large corporations, i.e., the companies whose shares are going up.

Disney figures in another corporate property transfer.  Ever since the dawn of aviation it has been held that airspace belongs to the public and is to be regulated for the benefit of all by the FAA.  This is what, for example, prevents the owner of a farm in Missouri from demanding that Delta Airlines pay him a tax every time they fly over his farm.  In May of this year that changed for the first time.  Disney essentially now owns the airspace over Disneyworld and Disneyland and they can exclude anyone from overflying.  They’d been trying for years to exclude planes towing advertising banners but Sept. 11th gave them a security rationale (though neither the TSA or the FAA felt there was a security risk or wanted to transfer the airspace into private hands).  Background story:

Let’s hope the comments section will fill up with other examples of this trend.  But the bottom line is that the time seems ripe to invest in the S&P 500.  Look around you at stuff that you believe to be public property.  Very likely it will soon be given away to America’s largest corporations and consequently their stock will go up even if they don’t innovate.

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Dumping money blindly into index funds?

If you put money blinding into stock index funds, you’re helping managers steal from America’s public corporations, according to a special issue of Fortune magazine (start here and then click on the other articles under “special package”).  Could it be that the great investing lesson we learned from the last few decades, i.e., that index funds outperform managed mutual funds, will turn out to be inapplicable to the changed environment of the 21st century?

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Wall Street gets fined

The Wall Street firms will pay $1.4 billion for their sins of the 1990s, under a settlement reached yesterday.  It seems that they instructed their analysts to recommend buying the stocks that their investment bankers were taking public (for a fixed 7 percent share of the proceeds that seems to have been as unaffected by competition as the 6 percent collected by realtors).  This happy marriage resulted in an explosion of profits for Wall Street throughout the 1990s.

How discouraged from defrauding investors are they going to be in the future?  According to the New York Times, Citigroup paid $400 million or 0.2 percent of their organization’s value (about $200 billion according to  Merrill Lynch paid $100 million or about 0.25 percent of its market capitalization.

Let’s figure out what this would be like for the average American family, whose median wealth was $63,000 in 2001 (before the economy collapsed).  0.2 percent of $63,000 would correspond to one of the family members being fined $126, less than one-third the cost of the average speeding ticket (including insurance hikes) in the U.S.

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