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5 things to ask your friends who think “this time is different”

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buyinghigh_dumb

I love to make fun of economists and engineers, who get really mad when you point how humans act irrationally and how their “models” are therefore wildly off-base because they never deign to talk to psychologists in all their infinite wisdom. In fact, here are some of my favorite links on investor psychology and psychology book recommendations.

To show you what I mean, here’s another thought-provoking guest post from Carl Richards at behaviorgap.com.

Carl Richards: 5 things to ask your friends who think “this time is different”

“Given the decade we just finished, the question about what to do now is becoming part of our national conversation. With the insane amount of noise in the press, here are a few things to think about.

First some assumptions:

  1. Your long-term investments are super diversified and low cost (broad-base, index funds, for example).
  2. You are only investing money in stocks (see #1); that is long-term.
  3. You have a plan for meeting short-term needs.

With that out of the way, here are a few things to think about:

  1. The Sunk Cost Fallacy: We all have a tendency to look at the money we have already lost and think that we need to sell because we have lost so much. How much we are down has nothing to do with what the best decision is NOW. What is important is that we focus on making the best decision now, looking forward.
  2. Anchoring: We are wired to take the recent past, anchor to it, and project it into the future. You start to do calculations like, “If the next decade is like the last I would be better off putting my money under my mattress.” We do this when times are good (in late 1999, eight out of every 10 dollars invested went into tech funds, right after a 80% run), and now we are doing it in bad times. Do we really think that this is the end? Are we really never going to solve these problems? Should we all move to the hills to grow our own vegetables? This is one whopper of a cycle, BUT IT IS STILL A CYCLE.
  3. Why are stocks the only things that Americans buy when they are marked up and sell when they are on sale? If you thought stocks were a good investment in 2006 and 2007 (and we all did), then wouldn’t they be even better when they are a lot cheaper?
  4. The question of the day is do you think that stocks will outperform cash and bonds for the next 10 years? The U.S. government is offering to pay 3% on a 10-year treasury. After taxes and inflation that will cost you money to own. Do we really think that if you bought a broadly diversified portfolio of stock mutual funds and then committed to completely ignore it for 10 years (not 10 days or 10 months) you would be better off sitting in a CD?
  5. What we are talking about is expected future returns. The fact that we just had one of the worse decades ever, means that expected future returns went up, not down.

Just a few things to think about as you make changes to your 401(k) or your investment plans. It is scary out there right now, but it seems irrational to assume that this will be the first time ever that a bear market never ended.”

Check out more about investor psychology at Carl’s blog behaviorgap.com.

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25 Comments

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  1. First let me say that I mostly agree with the author that people do fall victim to some of the faulty thinking that he lists but he takes some similar faulty logic and applies it in the other direction…

    “If you thought stocks were a good investment in 2006 and 2007 (and we all did), then wouldn’t they be even better when they are a lot cheaper?”

    No, the present values of expected future cash flows from these companies are rightly lower than they were in 2006 and 2007. You’re buying a worse thing for a lower price and that’s fine but it’s not better.

    “What we are talking about is expected future returns. The fact that we just had one of the worse decades ever, means that expected future returns went up, not down.”

    I’m sorry, this is not correct. We just had one of the worst decades ever but that does *not* mean that we should suddenly expect a bigger increase than we did before the crisis – that is almost as bad as saying: “Things went down, zomg, they’re always going to go down” which the author correctly chided people for thinking. Though the markets are not entirely efficient, they are efficient enough that most normal humans cannot market time. We did expect before this and should expect now to have a reasonable increase over the very long term but my expectations now are not higher because of this crisis than they were before.

  2. […] Ramit err’ “Carl Richards – 5 ?’s to ask your friends who think this time its diff… […]

  3. Agreed. Go look at the past 10 yr return or even the past 20 yr return. You actually would have been BETTER investing in Treasury bonds. Timing is everything-just ask people who were about to retire now. Check http://www.mebanefaber.com, a simple timing model can be followed to improve your returns.

  4. @Oliver:

    Thanks for the comment. Lets start with some assumptions:

    [1] The long term average of the S&P is around 10% [actually 11.26% from 1926 – March of 2009]

    [2] Returns tend to revert to that long-term average

    [3] It is reasonable to use history as a guide to make our judgements about the future

    We could take a entire post to argue any one of these assumptions, but for sake of this discussion lets just use then as a starting point:

    Then it would follow that after a 10 year period where the average annual return was 17.4% [like it was at the end of 2000] you would have to adjust you expected future return DOWN from the last 10 years, because they were so much higher then the long term average.

    Likewise when you have a 10 year period where the average annual return was -1.4% [end of 2008] then logic would dictate that your expect future return would go up because the last 10 years we so much lower than the long-term average.

    My point here is not so much that you should use this as timing tool, it is just to point out that it is flat out dumb to be pulling money from you home equity in 2000 & 2006 to buy stocks [right AFTER a HUGE ten year period] and then when prices in the aggregate are lower be so scared you can’t sell fast enough.

    IF you agree with assumption 1,2, and 3 then it seems to me the best solution is to find an investment you can stick with and add money to it in an automatic, unemotional, disciplined, way independent of what the market is doing.

    If you want to take it one step further do what Buffet suggests: “Be greedy when everyone else is fearful and fearful when everyone else is greedy”

  5. A couple of thoughts. First, stocks are not the only thing people buy when they are marked up. In fact, I think the best example is housing, not stocks. Pretty much everyone got sucked into the myth of “housing will always go up.”

    Secondly, there is NO INFLATION right now. I know this is a hard concept to grasp (as I don’t see many financial blogs talking about it), but price inflation is nonexistent right now.

    Have to take a time-out here and talk about the CPI (consumer price index.) Is anyone surprised to learn that the government is basically pulling numbers out of its butt for a large part of the CPI to make it look better? No? Good. Let me explain.

    A large part of the CPI is something called “Owner’s equivalent rent,” or OER for short. This is basically where the gov’t calls up a bunch of homeowners and asks “How much do you think it would cost for someone to rent your house?” This is not only subjective, but stupid. The result is that the CPI understated inflation for years and is now overstating it.

    We have real housing price data to go on…the Case-Shiller housing price index. By taking out OER and replacing it with the Case-Shiller data, we quickly find that price inflation is -5% year over year.

    That means prices actually FELL 5% since last year. Unusual, but not unheard of, especially in a recession.

    More info and charts: http://globaleconomicanalysis.blogspot.com/2009/04/cs-cpi-negative-50-third-straight-month.html

    So your 3% 10-year Treasury is actually returning 8% assuming another 5% fall by this time next year. And it may take us a while to get back into inflation territory.

    This calls into question a bunch of your other numbers. But not to mention that you really should have done the research pointed out by other commenters to find that bonds outperformed the stock indexes over the past 10 years.

    What do I invest in? I follow Graham’s value investing strategy and buy dividend stocks.

    -Erica

  6. Many stocks did not recover from the depression until 1954. same goes for real estate. that’s a long time to wait for a ROI

  7. “Thanks for the comment. Lets start with some assumptions:”

    reminds me of a relevant joke. An engineer, a chemist and an economist are on a desert island.

    fortunately, several cases of canned food washed up with the wreck.

    The egineer says ‘ i will build a device from rocks that can smash it open.
    The chemist says ‘too messy, i can device an acid from some of the plants and minerals that will burn the cans open”

    The economist sneers at them condescendingly and says “You’re both wrong, the solution is simple….ok, let’s assume we have a can opener”

  8. @Erica: I have done the research, and it is true that bonds outperformed stocks over the last decade, but that really had nothing to do with this conversation. The point here is really rather simple: buying high and selling low is dumb.

    We can debate the details all day long, but the fact is that most of us could not buy enough in 99, and early 2000 RIGHT AFTER one of the best 10 year periods ever, and now we are all running to buy short-term bonds and CD’s with bond prices close to historical highs and 5 years CD’s yielding 3.5%.

    If you agree that the stock market will follow it long term trend then this behavior just doesn’t make sense.

    @ME: that is a great joke!

  9. Carl, the only problem I see with the argument is that most people who think this time is different are simply ignorant to history. The people who think “times have changed” or “we’re in a new paradigm” are the people that simply did not understand their investments or the nature of investing to begin with.

    Your posts leads us to assume the people that sold low or bought high were rational to begin with and their opinions have changed. They never were rational, the lack of rationality is what leads people to think this time is different.

  10. Great post, Carl, and thanks for sharing this, Ramit.

    I think the real takeaway from this topic isn’t what’s happened or what might happen in the future (I don’t know and neither do you).

    The real message is here is what Carl writes about at length on his site. It’s all about your BEHAVIOR.

    Actually, whether you’re invested in index funds, treasuries or the “hot stock du jour”, your actual investment vehicle will have less impact on your investment experience than will your behavior.

    Let’s say you buy the absolute best investment at the absolute best time. I don’t believe in market timing or stock picking, but less make some assumptions here. The fact that you had perfect timing doesn’t matter at all unless you have the discipline (behavior) to stick with it during the inevitable ups and downs of the market.

    The crux of investing. IMHO, is making important decisions in the face of uncertainty. And it’s not just the decision to start investing, it’s the daily decision to stay invested. That’s where your behavior will make or break your investment experience over time.

    Often times, the best investment advice is “Don’t just do something, stand there.”

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