The market does not determine value
This post is about our capacity for independent thought, or lack thereof. It is also about the impact of the stock market on our ability to think independently. I’m inclined to think that the ability to think for ourselves is one of the most important qualities of successful investors.
One reason this is important is because serious investors must make a distinction between price and value. They should only buy a stock at a very attractive price and not over-pay.
The views of others
Humans seem all too affected by the views of others. The issue comes up in many contexts. At the most extreme is the madness of crowds and mobs. Such madness is a real pathological human trait. Herd and lemming-like behavior are also fairly extreme.
More subtle are peer and career pressures. More subtle again and still very powerful is group thinking (Groupthink).
And then there are the forces that cause us to do what others are doing because we believe that what everyone else is doing must be right. This has been called ‘social proofing’.
Finally, behavioral psychology tells us about the dangers of heuristics, anchoring and priming effects.
Do investors truly exercise their judgement about the market?
Here’s one man’s view. Professor Robert Shiller (Nobel Prize) tells us that: “the popular notion that the level of market prices is the outcome of a sort of vote by all investors about the true value of the market is just plain wrong. Hardly anyone is really voting. Instead people are rationally choosing not to, as they see it, waste their time and effort in exercising their judgment about the market, and thus choosing not to exert any independent impact on the market.” (Shiller, Irrational Exuberence. 2005 Second Edition) p.160.
Answering an easier question
Humans, as Professors Kahneman and Thaler (both have Nobel prizes in economics) have told us, are neither fully rational nor completely selfish. We often take short cuts. One of the central themes from Kahneman’s work is how humans generate intuitive answers to complex questions. He believes our brain will find a related but easier question to answer. We use this as a short cut. He calls it using a heuristic. This heuristic alternative to careful reasoning sometimes works fairly well and sometimes leads to serious errors. (Kahneman, Thinking, Fast and Slow 2011) p.98.
This alternative to careful reasoning may cause us to answer the question of what is the fair value of a stock by asking the question, what is the ‘market value’? Which is, in effect, erroneously asking other investors what they think the fair value is. The answer we get is price not value.
There is another psychological effect at work when investors are thinking about the fair value of a stock or the market as a whole. It’s called anchoring, and again, it can lead investors seriously astray.
We need to consider the impact of observed prices on investors’ thinking. One mechanism at work is what Daniel Kahneman calls Anchoring and Priming.
As to Anchoring, Kahneman writes: “This is a very common effect. It occurs when people consider a particular value for an unknown quantity before estimating that quantity. What happens is one of the most reliable and robust results of experimental psychology: the estimates stay close to the number that people considered – hence the image of an anchor. If you are asked whether Gandhi was more than 114 years old when he died you will end up with a much higher estimate of his age at death than you would if the anchoring question referred to death at 25. If you consider how much you should pay for a house, you will be influenced by the asking price.” (Kahneman, 2011) p.119.
The way anchoring works is through suggestion. Kahneman writes: “… suggestion is a priming effect, which selectively evokes compatible evidence.” (Kahneman, 2011) p.122.
Kahneman writes: “Many psychological phenomena can be demonstrated experimentally, but few can actually be measured. The effect of anchors is an exception. Anchoring can be measured, and it is an impressively large effect.” (Kahneman, 2011) p.123. In our investing, when we consider the intrinsic value of a stock, the market price acts as a prime and as an anchor.
In one fascinating and striking conclusion, Kahneman notes that: “a key finding of anchoring research is that anchors that are obviously random can be just as effective as potentially informative anchors.” (Kahneman, 2011) p.125.
Professor Shiller tells us: “In making judgments about the level of stock prices, the most likely anchor is the most recently remembered price. This tendency of investors to use this anchor enforces the similarity of stock prices from one day to the next. Other possible anchors are remembered past prices, and the tendency of past prices to serve as anchors may be part of the reason for the observed tendency for trends in individual stock prices to be reversed. Another anchor may be the nearest milestone of a prominent index such as the Dow, the nearest round-number level, and investors’ use of this anchor may help explain unusual market behavior surrounding such level.”
“For the individual stocks, price changes may tend to be anchored to the price changes of other stocks, and price-earnings ratios may be anchored to other firms’ price-earnings levels. This kind of anchoring may help to explain why individual stock prices move together as much as they do, and thus ultimately why stock price indexes are as volatile as they are – why the averaging across that is inherent in the construction of the index doesn’t more solidly dampen its volatility.”
He adds reference to a number of other price phenomena and concludes: “Indeed all of these anomalies noted in financial markets have a simple explanation in terms of quantitative anchoring to convenient numbers.” (Shiller, 2005 Second Edition) p.149.
Here, our brains are primed by an associative memory “hidden from our conscious selves”. (Kahneman, 2011) p.52. Priming causes the behavior of investors to be very much influenced by “the environment of the moment”. (Kahneman, 2011) p.128 (Emphasis added)
Warren Buffett tells us: “People are habitually guided by the rear-view mirror and for the most part, by the vistas immediately behind them.” (Buffett W. , 2001).
Kahneman writes: “The main moral of priming research is that our thoughts and our behavior are influenced, much more that we know or want, by the environment of the moment. Many people find the priming results unbelievable, because they do not correspond to subjective experience. Many others find the results upsetting, because they threaten the subjective sense of agency and autonomy.”
Herding and Groupthink
There are other psychological effects at work that impact our capacity for independent thought, e.g. herding and groupthink. It would make this post too long to get into them. I’ve written posts on these topics: see here and here. In essence we run with the herd rather than acting independently. We go along with the group because we think the group must be right.
The counter argument, supported by many commentators is that Wisdom of Crowds applies to the stock market. This counter argument is a fallacy. As I have noted in a post here, Wisdom of Crowds does not apply to the stock market. I think the better image is the Madness of Crowds.
I have developed some rules to promote independent thinking. I call them gap-to-edge rules. The idea is to counter the ‘behavioral gap’ and develop a ‘behavioral edge’. These gap-to-edge rules are designed to free us from urge to do what everyone else is doing.
Gap-to-edge rule: When all is going well in the stock market, be wary. When all is going badly, take heart from the opportunities that present themselves.
Be reminded of four of John Templeton’s Maxims.
Maxim 3. It is impossible to produce a superior performance unless you do something different from the majority.
Maxim 4. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.
Maxim 4. 1982 The time of maximum pessimism is the best time to buy. And vice versa. Buy when published predictions reflect an unusual level of gloom and sell when the consensus is unusually optimistic. This applies to share prices generally and also for particular industries.
Maxim 5. To put “Maxim 4” in somewhat different terms, in the stock market the only way to get a bargain is to buy what most investors are selling. (not in 1982 – he took 4. from 1982 version and split it into present 4. and 5. The last sentence of 4 from 1982 deals with both buying and selling and to individual shares and industries)
Maxim 6. To buy when others are despondently selling and to sell what others are greedily buying requires the greatest fortitude, even while offering the greatest reward.
Gap-to-edge rule: Do not to be contrary just to be contrary. We must be prepared to be contrary when our independent judgment tells us to be.
Sometimes the crowd is right.
Gap-to-edge rule: Maintain some physical and mental distance from Wall Street.
It may be no coincidence that two of the most successful investors of the last one hundred years lived and worked a long way from Wall Street. Both Warren Buffett, who has lived and worked in Omaha, Nebraska, and John Templeton, who lived and worked in Lyford Cay in the Bahamas, kept their distance.
John Templeton’s walks along the beach or sitting and watching the sea may have been one of his personal gap-to-edge rules. Today it might be called a habit of deliberate mindfulness. In a connected world, getting away from the phones allows you to disconnect. This is surely not a bad thing with all the pressures and problems of herding.
Gap-to-edge rule: Take nothing on faith from experts.
Analysts and other experts have many fine ideas and opinions. They also have many bad ideas, suffer from biases and make errors. Every recommendation should be supported by simple empirical evidence that a person of average intelligence can understand.
Gap-to-edge rule: Remember that when things seem too good to be true, they usually are.
Gap-to-edge rule: Don’t be afraid to be out of step with everyone else
Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
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