Valuation-Informed Indexing #243

by Rob Bennett

Yale Economics Professor Robert Shiller argued in his recent presentation to the Credit Suisse Group Asian Investment Conference that the human brain is “wired for stories.” He is making an important challenge to the conventional way of thinking about how stock investing works. The Buy-and-Hold Model posits that investors are rational actors. That’s why Buy-and-Holders don’t worry about mispricing; rational investors would never let overvaluation or undervaluation get too out of hand. But investors whose brains were wired for stories might do just about anything. Shiller is pointing us to a new and potentially very compelling way of looking at how stock investing works.

So I like his story idea a great deal. Still, I believe that it can be refined. I believe that a better way of stating the case is to say that “the human brain is wired for paradigms.” If it were just that we were impressed by stories, I have a hard time understanding why insane levels of undervaluation that apply for long periods of time would be as much a market reality as insane levels of overvaluation that apply for long periods of time. Yes, we tell ourselves stories to justify the folly that we engage in during bull markets. But why do we punish ourselves when our bull market follies come to an end? Why don’t we continue telling ourselves happy stories that support insane price levels? Why do bull markets always end in tears?

Our brains are wired for paradigms. Stories support paradigms. So storytelling is an important part of what is going on. But the key to understanding why investors destroy themselves over and over again is understanding how the human mind is attracted to paradigms. It is by learning how paradigms form and how paradigms are broken that we learn how to reduce the risk of stock investing dramatically.

A paradigm is a collection of beliefs that all support an overall belief system. We form them in our thinking about all issues. The human brain is a paradigm-producing (and paradigm-breaking) machine.

Consider how we form beliefs about political matters. Some of us are liberals. Some of us are conservatives. There is an odd phenomenon that occurs when an event takes place in the world and the people who meet at conservative discussion boards come to very different conclusions about it than the people who meet at liberal discussion boards. Say that there is one of these horrible killings at a school in which some mentally unbalanced person kills a number of people for no reason. Within minutes of the news being announced, you will see liberals drawing the conclusion that we need stricter gun control laws. Conservatives will in that same amount of time come to a different conclusion — we need to relax the gun control laws because people who are not mentally unbalanced can protect themselves from people who are mentally unbalanced only if they too have access to guns that can be used in self-defense in such circumstances.

There is no disagreement re the facts in these cases. And of course neither liberals nor conservatives control the market on truth or logic. How is it that liberals are so quick to see that the solution to the problem is an answer very different that the answer that occurs to conservatives?

Liberals and conservatives embrace different paradigms. Liberals generally trust government authorities to do what is right. When they see individuals acting in dangerous ways, their immediate reaction is to voice support for increasing the power of government authorities to limit the ability of individuals to do other individuals harm. Conservatives are more skeptical of the ability of government authorities to solve problems. Their minds jump to scenarios in which increasing government power might exacerbate the problem rather than solve it. So they quickly come to very different conclusions about what steps are needed to address the problem that has evidenced itself.

Bull markets are the product of an investor paradigm rooted in a belief in investor rationality. If investors are rational, excessive valuations are not a problem. If the belief that excessive valuations are not a problem becomes widespread, a bull market becomes inevitable.

Bear markets are the product of a breaking of that paradigm. The belief that investors are rational is false. Investors can maintain confidence in that belief only for so long. When the belief fails, prices crash and the bull market becomes a bear market.

To understand how bull markets become bear markets, we need to understand how paradigms collapse. Do liberal ever become conservatives or do conservatives ever become liberals?

Yes, that happens. It doesn’t happen easily. Liberals trying to convert conservatives (and conservatives trying to convert liberals) often become frustrated that arguments which they find compelling fall on deaf ears. That is the usual case. The human mind is drawn to paradigms for a good reason. If we didn’t make use of paradigms to organize our thoughts, we would need to reformulate our thinking on every issue every time new information appeared before us. That would be an exhausting and anxiety-provoking way to proceed through our days. Believing in paradigms gives our thinking continuity. A liberal remains a liberal no matter what events transpire and a conservative remains a conservative no matter what events transpire.

Until he doesn’t.

Paradigms serve an important purpose in giving our thinking continuity but the human mind would not be capable of big advances if paradigms never broke. Paradigms do break. There is a process by which conversions can be achieved.

This process takes places behind the scenes. A liberal on the road to being converted into a conservative notes aspects of the liberal paradigm that no longer appeal to him (perhaps he now has children and some aspect of the liberal paradigm that made perfect sense when he was single has becomes suspect). In the early days of the conversion process, he discounts the extent of the disconnect from his old beliefs. The inclination is to maintain the paradigm and to do that doubts must be suppressed. But in the cases in which a conversion eventually takes place, one doubt leads to two and two lead to four and four lead to eight.

Then there is a conversion. The liberal becomes a conservative. The doubts grow so great that the old paradigm is overthrown. The conversion appears to be a sudden thing. Few doubts are expressed until the day when the rejection of all beliefs comprising the liberal paradigm takes place in a flash. The reality is that confidence in the liberal paradigm had been eroding behind the scenes for a long time before doubts grew so numerous that it became impossible to suppress them any longer.

So it is in bull markets. Investors experience doubts about the stories they tell themselves to maintain confidence in the bull market for a long time before prices crash. Doubts grow and grow without being spoken of for a long time until the day comes when investors can no longer fool themselves that the bull market prices are real. And then the fantasy collapses in a dramatic and frightening way.

Rob Bennett recorded a podcast titled How Could So Many Have Been So Wrong for So Long? His bio is here.