This post has my personal notes from the book, Mean Markets and Lizard Brains by Terry Burnham.
THE NEW SCIENCE OF IRRATIONALITY
The most important question to answer is: Where should I invest my money?
The conventional answer to this is that if we want high returns we must take high risk. The best asset class to give us high returns is stocks. Markets are rational, therefore stock prices are not irrationally high at any time. Therefore we should invest in stocks.
The key question we have to answer is:Are markets rational? Are people rational? Are groups of people interacting in financial markets rational?
- If the answer is yes, then stocks are the best things we can buy.
- If the answer is no, we should invest in a different manner.
The lizard brain( primitive brain) often overrides the rational brain(prefrontal cortex) as it likes to look backwards and seek patterns. These can cause problems in successful investing.
The human brain is divided into two parts: the prefrontal cortex and the lizard brain. Abstract cognition happens in the prefrontal cortex. The lizard brain is that part of the brain that relies on instincts, habits and impulsive action. Our rational skills for finance are bad, filled with systematic errors and biases. We use our rational skills rarely when investing. When we use the lizard brain for investing, we become worst at investing.
Criticism is unpleasant. All human beings are built to make certain types of mistakes. We deny the truth that we are irrational. Winning requires critical self-examination.
The first question regarding irrationality is: Do individuals make good decisions? The answer is no. Some reasons are:
- We suffer from conjunction fallacy. The conjoined probability of two statements must be lower than for either of the individual statements. But we often think the conjoined probability is more. This is the conjunction fallacy. This is illustrated by the Linda problem.
- We are not very good at doing calculations. Sound investing is based on complicated mathematical analysis. It has been shown that simple problems trip up even MIT scientists.
- We are systematically overconfident. We are not aware of these shortcomings.
- We rarely use analysis to make decisions.
- Our prefrontal cortex is not in complete control of our behaviour. The subconscious has different and conflicting goals with the goals of the prefrontal cortex. The subconscious is sometimes smarter than the prefrontal cortex. Our rational brain often makes up stories for what the lizard brain does. Preconscious processing affects our fundamental perception of the world-the McGurk effect.
Some irrationalities that make us lose in investing are:
- In many financial situations, we are faced with taking a small loss now or possibility of a greater loss later. Pride often prevents us from taking the small loss now. Paul Tudor Jones had a sign that said this elegantly: Observe that the blade of grass that resists the lawn mower gets cut down, while the blade that bends remains uncut.
- Loss aversion: Our hatred of losing money can push us towards taking bad risks, which in turn causes us to lose money.
- We find patterns in random walks. Stock prices have a large random component, yet we try to find patterns in that noise. This is because of the lizard brain.
- We also have a self-control problem. Most of our bad decisions involve an inappropriate trade-off between today and tomorrow. We know that we should work hard now and play later, but we don’t. We place too much weight on the present and too little on the future. We use our lizard brain when we should use our prefrontal cortex.
Individuals are irrational when it comes to financial markets. But are people as a whole rational when it comes to financial markets.
The efficient market hypothesis says that prices at any given time are the right prices at that time. Therefore we will never buy overpriced or underpriced things in the financial markets. The tulipmania, and the stock market crashes are evidence of irrational markets but many do not accept them as evidence of irrationality. Similarly the fact that sentiment affects prices- greed of market gain leads to loss and fear of market loss leads to gain is evidence of irrationality. Superior performance exists, like that of Warren Buffet. The defenders of the efficient market hypothesis say that this just due to luck and not skill. But all the people who have made a lot of money accept that markets are inefficient. Warren Buffet says that he would be poor if markets were efficient.
One simple way to exploit market irrationality is: Buy when there is fear, sell when there is greed.
THE OLD ART OF MACROECONOMICS
Economics is simple. You can have debt or you can save cash. If you have a lot of growth, then you can fund savings from growth. If you do not have a lot of growth, you have to cut down on spending a lot.
Inflation is a monetary phenomenon. It is simple. When more money is created, the value of each piece of money decreases. This is inflation. In the US, the Federal reserve controls the money supply. Therefore their decisions will decide inflation. If there is inflation, then we should invest in gold, land and currencies other the US dollar. If there is deflation, then we should invest in bonds.
Some ways to protect your wealth against inflation and deflation are:
- Buy at today’s prices- your home, college tuition, commodity stocks, oil stocks.
- If you borrow, borrow at fixed rates.
- Buy inflation protected securities.
- Stocks can also act an protectors during price instability
By undervaluing currency, one can reduce current account deficit. A cheaper dollar decreases imports and increased exports, reducing the current account deficit. If you have high inflation, it also reduces the value of your currency. The US has a lot of debt. If you have a lot of debt, it is a problem for the bank, not for you. Similarly it is a problem for the creditors of the US. The US can print unlimited amount of money. So it is not a problem for the US. They can print a lot of money, undervalue their currency and pay off the debt. Or, it is possible that US people will save more and spend less and decrease debt. To decrease exposure to the US dollar one can buy non-US stocks and non-US bonds.
APPLYING SCIENCE AND ART TO BONDS, STOCKS AND REAL ESTATE
Bonds: If you believe interest rates will rise, you should not buy bonds. If you believe interest rates will decrease, you should buy bonds. Over the last 20 years, interest rates have been decreasing and we have made a lot of money in bonds. But even if interest rates go down to zero, there is not a lot of money to be made. Interest rates are more likely to rise. The best way to protect yourself against this is:
- Borrow at fixed rates
- Borrow less
- Buy short term bonds.
Once the interest rates rise, you can buy bonds at higher rates and reduce risk further.
Stocks: Compare the earnings yield on stocks to 10 year treasury bond. If the earnings yield is higher, then stocks are not overvalued. But making profits from stocks is a entirely different matter. However stocks over the long run have given at least average returns and hence it is worthwhile to have a proportion in stocks.
- P/E>30= expensive
- P/E- 20-30=overvalued
- P/E-10-20= solid value
PROFITING FROM THE NEW SCIENCE OF IRRATIONALITY
- Never trade emotionally, and trade as little as possible.
- Never trade on other people’s tips. Treat your own ideas for trades with some skepticism. Never trade impulsively. Always include a significant delay between an investment idea and an actual trade.
- Never average losers. Buy more of an investment only when ( and if) it increases in value.
- Do not dollar-cost average. Unless you have some secret knowledge that we are not in an bear market, do not dollar cost average. Remember, losers average losers.
- Keep your financial news flow consistent with your decision time frame. As much as possible, turn off the TV during the day, and don’t look at your portfolio.
- Look at your financial position in an aggregate fashion. In particular, be sure to combine any defensive positions with other investments that are being protected.
- Keep your investment positions conservative enough so that you preserve both options of increased risk or decreased risk should others panic and present you with an opportunity. Choose the time to go ‘all in’ carefully and scale down quickly.
- Those who trade too much should arrange their finances so that impulsive trades are not possible. Remove temptation; do not expect to resist it.
- Don’t trade in the red zone. Get out of losing positions quickly. Don’t trade in the emotional red zone. If an investment is eating away at us, exit. If you avoid the red zone, you will be able to: go on vacation for weeks without looking at the financial markets, increase or decrease any position, take large price changes in all markets without having to buy or sell anything, sleep without thinking about investments.
- Allocate more money to lower risk assets: value stocks, cash, bonds
- Buy tips and stocks of companies that make things that go up in price(drug companies)
- Buy short-term bonds
- Buy a smaller house with the hope of buying a larger one later
- Have a fixed rate mortgage
- Invest in other currencies
- Pay off debts
- Seek a secure paycheck
Four keys to profiting from mean markets
- Be different
- Make the investment moves that do not produce dopamine
- Make an emotionally realistic financial plan
- Be tough enough to stick to a plan