Contents
Stock Market Crushes
Markets Are More Than Simply Irrational—They Can Be Mean
Photographic Evidence: Scientific Evidence of Sentiment Predicting Stock Price Changes
Some People Get Rich by Selling High and Buying Low
Photographic Evidence: Predicting Coin Flips
A Hypothesis Masquerading as a Theory
Sell the Fads, Buy the Outcasts
An Instinct for Losing Money
Opportunities occur periodically in many different markets. In all cases, winning requires a willingness to challenge the conventional wisdom. During the inflationary 1970s, Andrew Tobias, the personal finance guru, literally had to deal with a mob in order to profit from an irrationally high silver price. 21
Throughout the inflationary 1970s the price of silver rose by more than 1,000% until it exceeded $40 an ounce. At the height of the frenzy, Tobias decided to sell some of his physical silver. He went to a retail location that bought and sold precious metals including silver and gold. As he approached the store he saw a huge crowd and thought it was too late. Everyone, he supposed, had realized that the price of silver was too high and had gathered to sell.
When Tobias reached the store he discovered to his delight that the crowd was gathering to buy! Soon afterwards, silver prices plummeted and more than 20 years later silver still sells for under $10 an ounce. Similarly, in 1970s gold prices soared toward $900 ounce before crashing, and today it sells for less than half that price.
In the late 1970s precious metals were the investment craze, and they were terrible investments. In order to profit, Tobias had to lean into the prevailing opinion by selling while all of those around him were buying.
Usually the mob is not physically present, but rather represented in the prevailing views of "the knowledgeable." In 2000, I began dating Barbara. As a joke, I told Barbara that we would have enough money to get married and have a baby if the buy stock price of EMC fell from $100 to below $50 (I was betting against EMC's sell stock price by shorting the shares).
Barbara is an archeologist and before this baby challenge she had never paid any attention to financial media. Now she began to listen, and the more she learned about EMC, the more she worried. Every single mention of the stock, in every venue, detailed the virtues of the EMC and predicted that the shares would continue to rise. Wall Street analysts and mutual fund managers appeared on TV and described how EMC's markets were growing and the stock was a "no-brainer," and a "must own."
Under the deluge of praise, Barbara asked me what I knew that these pundits did not. Did I think EMC had bad products? No. Did I have some inside information that EMC sales were bad? No. Did I know of competitors that would steal EMC's customers? No. Well, she demanded, what did I know? I told Barbara that I knew all the analysts and mutual fund managers loved EMC and that was enough. Barbara responded with "that is so Zen." With universal praise and love, the stock had nowhere to go but down, and down it went from over $100 a share to below $4.
The story of precious metals in the 1970s, and EMC more recently, form a universal pattern. Both Wall Street and Main Street have an amazing ability to be wrong about investments. At about the same time that Andrew Tobias was selling silver at ridiculously high prices, unloved stocks were being sold for rock-bottom prices.
This is one of the job descriptions that you will never see posted. For obvious reasons, $100 bills cannot remain visible for long. Because $100 bills tend to get picked up, believers in efficient markets assume that they can't exist. An alternative, however, is that there are opportunities to make profits, but they persist only in what can be thought of as the lizard brain's financial blind spots.
Market opportunities will be difficult to find. There are no easy roads to making money. In The Godfather: Part II, a young Vito Corleone does the favor of hiding some guns for his neighbor Clemenza (Vito goes on to become the Don and Clemenza one of his trusted lieutenants). After the guns are returned, Clemenza says, "A friend of mine has a nice rug. Maybe your wife would like it. ... It would be a present. I know how to return a favor."
As the two men go to pick up the rug from the "friend's" house, it becomes clear that they are actually stealing. In the process, a policeman comes to the door and Clemenza prepares to shoot the officer. Fortunately, the scene resolves itself without any violence, but the quest for possessions, whether by legal or illegal means, isn't an easy one.
While the $100 bills we seek are not easy to find, interestingly sometimes the hardest things to spot are those hiding in plain sight. For example, with modern electronic-search capabilities, the FBI can track most people down very easily. Special agents enter some information about the suspect into the computer, click a few keys, and voila, the suspect is found. Among the hardest to find, however, are people with common names like John Smith. So one of the few ways left to hide from the FBI is to hide in plain view, by being part of a crowd. This problem has complicated U.S. efforts to prevent bombers from boarding planes. There are a large number of people, for example, with the name Mohammad. Thus, many international flights have been cancelled because of mistaken identity.
In the case of markets, the opportunities exist, but the lizard brain is built not to be able to see them. During the dot-com bubble, the unprofitable Internet retailer Etoys was worth more than the profitable, and much larger, Toys R Us. Recognizing that Etoys was irrationally priced (and in fact soon went out of business) didn't require any fancy math.
While profitable investing doesn't require mathematical prowess, it does require a willingness to learn about the irrationality in oneself, in others, and in markets. Becoming a successful investor requires a keen understanding of human frailty, including one's own limitations.
We've encountered many of those limitations in Chapter 2. Two additional aspects of the lizard brain are harmful to investing success. The first is our desire to conform, and the second is the fact that our emotions really do seem to be out of sync with financial markets—both of which tend to lose us money.
One of our human limitations is the desire to conform to the majority. This seems to be something built into us and it works against us since popular investments tend to be unprofitable.
I learned something about this a few years ago at a football game between my Detroit Lions and the San Diego Chargers. My Lions lost the game, which was not surprising, as they've had a long tradition of mediocrity. What was surprising was the level of pain that I felt. The game was played in San Diego, and I was almost the only Detroit fan in a sea of Charger fans. The pain of losing in this setting was far greater than any I had experienced in home losses.
The human desire to conform to those around us extends beyond sports stadiums. A line of psychological research performed by Professor Solomon Asch and others demonstrates the pressure to conform. 22 In one setting for this research, six people enter a room and are asked to answer a question for which there is a clear answer. For example, here is a reference line:
X
Which of the following lines matches the length of the reference line?
A B C
Of the six people answering the questions, five are "confederates" of the experimenter, which means they give false answers designed to manipulate the behavior of others. In this case, the experimenter first asks the confederates to rate the lines, and they all give the same wrong answer. In this case they might say, "Line C matches line X."
After the five confederates have made these obviously false statements, the sixth person (who is not in on the experiment) is asked the same question. Now this person faces a bit of a quandary. Should he or she pick the obviously correct answer (A) or pick the same answer as everyone else (C)? In the original experiments, 75% of subjects sometimes conformed to what is labeled the "false consensus" by picking the obviously false answer (C).
More recently some of these original results have been challenged, but the basic finding seems intact. We seem built to want to be part of the crowd, even when doing so contradicts our direct observation.
In the case of the lines, the correct answer is obvious. In the case of investments, the correct view is rarely so evident. Consider again the situation of Etoys versus Toys R Us. While it appears obvious in retrospect that Etoys would go bankrupt, imagine the pressure to conform. Day after bubble day, people (many of them professionals) bought the stock at high valuations. In such cases, our brains seem built to start believing what others are saying.
To do well, an investor has to purchase exactly that which is unloved. This requires an ability to take the emotional pain of being different. I recall my broker's mocking laugh when I placed an order to buy Treasury bonds in early 2000. Bonds had been going down consistently and all the "smart money," he said, was selling not buying.
Unlike my Detroit Lions story, the bond story has a happy ending. As usual, the common consensus was wrong, and the bonds that I bought soon increased in value. The successful path was the path that was scorned.