Has our financial behavior changed since we were cavemen?
One of the most interesting interviews in my new book, The Best of Goldstein on Gelt 2012, is with Ken Fisher, the founder, chairman and CEO of Fisher Investments Company. Ken, who is also a Forbes’ portfolio strategy columnist, and author of Markets Never Forget (But People Do) shared some fascinating insights into the origins of our financial behavior and outlook. For example, when it comes to money management, is our outlook that much different than that of our ancestors? S
Read a transcript of this interview to get answers to this question, and scroll further down the page, to watch a video of the interview.
Douglas Goldstein: Some of your research focuses on the link between the stock market price/earnings ratios and stock prices. Can you tell us something about that?
Ken Fisher: Much of what we commonly believe about things is because of the way our brains work rather than the things themselves, but many people have difficulty with this. Our brains were set up to process information a long time ago, but they were not really set up to deal with the kinds of modern phenomena that we encounter today, and we process this information through these old processors. Things like price/earnings ratios are ones where we routinely presume, because our brain naturally assumes, that high P/Es are riskier than low P/Es, and this becomes part of a common culture that is widely accepted. People agree on it, but the fact remains that almost any time I put any information in a framework that is a framework of height, people will always see a heights framework as risky. This is because we are descended from people for whom heights were inherently risky if you fell. You would likely got killed or maimed, and if you were maimed, it was almost as bad as getting killed in those days, so heights were risky.
For example, if you pick a high P/E and flip it into an E/P, which would be earnings divided by price, and think of that as an interest rate as compared to other interest rates, the heights framework goes away and the comparative cost of money becomes more important. You become more rational and analytical, and you get closer to a reality that makes sense in an economic way, but if you just think in terms of P/E, people auto default that high P/E is risky and low P/E is safe. Meir Statman and I have done a lot of work on this subject that was published long ago, and any way you measure it, looking at one, three, or five years doesn’t tell you anything at all about risky returns.
Douglas Goldstein: If you’re buying something and paying 30, 40, or 50 times earnings, it sounds very expensive. But you’re saying that that’s just how we are programmed to think, and it’s not really the reality of how the market works?
Ken Fisher: High P/E stocks over one, three, and five-year periods don’t have a markedly higher or lower return than low P/E stocks, except in the periods where high P/E stocks do better and periods where high P/E stocks do worse. But if you take out just a very few, which you could think of as outliers, and outliers are always things that a statistician wants to throw out, it’s likely not to be very meaningful, and just look at the bulk of the returns. You don’t see any effect that actually leads you anywhere in a predictive sense that anybody would ever want to bet on, and yet that’s what our brains want to do.
The same is true if you think of, for example, total markets. People generally believe that things like markets are less risky when the market’s P/E is low. They are more risky when the market’s P/E is high, and you can just measure looking at one, three, and five-year returns how many times the market deep-ends at this P/E level, that P/E level, and the other P/E level. High P/E tells you nothing about whether it will go up or down in the next year or by how much, because for every example that you can give me a high P/E market that has done terribly, I can show you a comparable example of how an exactly identical high P/E time period over the next 12 months did wonderfully. It’s actually 50/50, and the same is true with low P/E. Low P/Es sometimes do wonderfully, sometimes they do terribly, and if you look again at one, three and five years, it’s very 50-50, but yet, that’s not what our brains want to believe, so that’s not what our brain sees. One of the key tenets of behaviorialism is that we tend to see information that confirms our prior biases and we tend to be blind to the information that contradicts some of these.
My newest book, which came out last year, called Markets Never Forget (But People Do), is just a chock-full of examples of things where our memories just don’t work for us in showing us what it is that we’ve often seen many times before. But because it’s inconsistent with our prior bias, we don’t accept it, so we don’t see it and we’re blind to it.
One of the amazing points about our brains and our memory is that some of our memories are very good. We’re very good at recognizing facial patterns, for example, and holding them for a very long time period and being able to recognize somebody that we haven’t seen for 20 years, even though their face changes and ages. We’re really good at doing that, but that’s a really old thing that we’ve done for a very long time with people. A lot of the financial frameworks are things that we have never dealt with at all. So what we tend to do is believe what all of our friends believe, so if they believe it, we tend to think it’s true, which reinforces our tendency to believe it. Yet in fact, you need to check it out for yourself to see if it’s really true because most of what you believe isn’t really true. People find this troublesome, and they also find it too much work, and yet the whole role of markets is to take advantage.
Are We Still Inside the Cave?
Douglas Goldstein: One of the very common numbers that comes out and affects the markets all the time is consumer confidence. How does that affect stock returns?
Ken Fisher: Consumer confidence is something that is largely and overly simple, since it moves with the market at a very slight time lag. If you know what the stock market has done in terms of the global stock market, you know pretty much where the consumer confidence numbers are going to come out. When the market goes up, rising and performing well, consumer confidence tends to rise. When the market falls, consumer confidence numbers are often updated and revised a little bit after they’re initially released, but the revised numbers largely have a slightly lagged effect to the stock market. The stock market is telling you the same thing, what consumers feel, and it’s all about how we are feeling. The point is so simple that most people don’t want to believe it. For example, in the media, it regularly says that you should be more optimistic because consumer confidence is up and that’s the sign that things will be better ahead. On the one hand, the stock market is in of itself the leading indicator, and it always has been both on the upside and on the downside, but an improvement in consumer confidence is really a statement that the stock market has already been up. It’s not because consumer confidence is up, so you should be bullish, or that because consumer confidence is down, you should be bearish.
We see lots of these things, but we’re just unwilling to accept them because we don’t want to accept them. The most egregious that I know of are all of the features that surround deficits and debt. We have heavy biases in the Western world and much of the rest of the world. Everything that has to do with debt is that debt is bad and more debt is worse, but whatever bad things we think about debt, there are lots of examples that contradict it. But people don’t want to look at those examples. They want to look at examples of where somebody had debt and they got into trouble, and therefore, this reinforces their view that this is bad. The willingness of people that contemplate that their bias might be wrong is very low, very small. And in markets, people are very egotistical, and so there’s this tremendous desire to see what behavioralists call accumulating pride, which is, “I bought it and I’m smart. So you want to see me do it again?” and that tendency really doesn’t want to challenge its own belief system, because when you challenge your own belief system about basic things, it’s a scary notion if you’re ego-driven.
Douglas Goldstein: If you were to give advice to regular investors, what would be the number one thing that people should be doing when they’re beginning to work on their own finances?
Ken Fisher: I presume that if you’ve been right, you’re probably lucky, and if you’ve been wrong, you should be focusing on learning something that changes some set of beliefs that you have. Otherwise, maybe you’re overconfident, and if you’re overconfident, maybe you shouldn’t be making your own decisions. There’s a tremendous tendency among humans of all types to be overconfident, to presume that they can make decisions that they don’t have a basis for as they don’t really know anything.
Finance basically says, to make a long story very short, that you need to know something other people don’t know, or when you make decisions, you’ll either be right because you’re lucky or more often be wrong and be worse than if you made no decisions at all. I decide I’m going to buy stock X because I really like the new product that they’re coming out with. If it goes up, so you think you were smart. If it goes down, you think, “I didn’t really decide to buy that stock; the broker sold it to me.” The fact is, what a financier would say is that if you didn’t know something that other people didn’t broadly know, you shouldn’t be making the decision, and if you’re going to be an investor, you should largely just be passive. The part that says “I want to give up my overconfidence” is a very hard thing for most people to do.
The fundamental basis of investing should include an extra dose of pre-plan humility that is actually very hard for many people to engage in. Most people fall for this notion that behaviorists call “accumulating pride” and “shining regret,” which associates success with scale repeatability and associates failure with victimization or bad luck. Our ancestors accumulated pride and shining regret in almost everything they did, which motivated them to keep trying. We are the descendants of people who were very heavy triers. You need a fair amount of confidence to take a stick with a stone point on it and run up next to some large animal in order to stab it and take it home. And it takes a fair amount of willingness to take a risk that you don’t get trampled in the process and killed yourself. We are the descendants of people who were very successful at engaging in these activities, where they were on the one hand overconfident, but they were good at what they did, compared to others who are not their descendants because they didn’t pass on their genes. The fact is that that overconfidence plays really well in a lot of environments.
So, in a distant time in a tribal format, one guy had to go into the north, to the east, to the south, to the west, and the guy that comes back at the end of the day with a couple of gazelles over his skin is a big hero around the campfire that night. The guy that comes back with nothing for the day gives a lot of excuses as to why it wasn’t his fault. The winds were blowing the wrong way, there were big noises in the area that scared all the gazelles off, the neighboring tribe were making a lot of noise, but nobody really appreciates all the excuses. The next day, everyone goes out hunting again. The guy with both gazelles from yesterday has turned into a real hero around the campfire and people are talking about how maybe the chief is going to have the guy marry one of his daughters. But the guy who was unlucky the day before may actually just stumble on a gazelle that had mangled its leg and can’t get away, and even if he’s a terrible hunter, he brings back the meat because he got lucky that day, and that’s still good for the tribe. The one that came back with the two gazelles accumulates pride as around the campfire, they associate his success with scale repeatability, while the one who comes back with nothing associates his failure with victimization or bad luck. That allows them to continue trying the next day, which for the tribe is a good thing.
We, as people, have been hardwired for millennia on accumulating pride and shining regret, and in the environment that we came from, it is actually a beneficial feature to our society. In the environment where we’re engaged in security transactions and capital markets, it builds the overconfidence that causes us to do things that we really aren’t able to do. The market then takes advantage of us, which is central to some of the basic tenets of behaviorialism.
Douglas Goldstein: I’d like to thank you very much for your time on the show and I hope that we will have you back on here again soon.
Disclaimer: This article is for educational purposes and is not a substitute for investment advice that takes into account each individual’s special position and needs. Past performance is no guarantee of future returns.
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