Valuation-Informed Indexing #252
by Rob Bennett
I enjoyed a “click” experience when writing a recent article about how the famous Ashe research of the 1950s relates to stock investing.
The Ashe research tested how study participants responded to the introduction of peer pressure aimed at influencing their assessments of the length of lines on two cardboard cards. The participants were shown one card with a line of a length of, say 12 inches. Then they were shown a second card with three lines, one of 12 inches, one of 6 inches and one of 18 inches. They were asked to identify which of the three lines on the second card was of a length that matched the single line on the first card.
Sounds easy, right?
It was easy. So long as the test was performed straight, study participants gave the correct response 95 percent of the time.
However, things changed dramatically when a dose of peer pressure was added to the mix. Fake study participants deliberately gave wrong answers before the true study participants were asked to give their answers. When this happened, the ability of study participants to give correct answers dropped dramatically. People who possessed the ability to say which lines matched suddenly lost that ability when they became aware of other people who seemingly did not possess that ability.
I wrote about the implications of the study on stock investing a few weeks ago at this space. It was one of those rare columns that stayed on my mind after I posted it. This study, which those who are familiar with the psychology literature have known about for decades, solves so many puzzles in the stock investing realm. As I have thought about it more and more, I have come to believe that the Ashe research is of huge significance to those trying to come to a fuller understanding of how stock investing really works.
Fama’s research showed that short-term timing does not work. But he misreported what he found. Fama looked only at short-term timing; he did not even try to determine whether long-term timing (changing your stock allocation because of a big shift in valuations, understanding that you may not see benefits for doing so for as long as ten years) works or not. Shiller was the first to publish peer-reviewed research on that question. Shiller showed that long-term timing (price discipline) always works and is always 100 percent required. Scores of studies published in the years since have confirmed Shiller’s finding. Yet most experts in this field claim to this day that it is not necessary for investors to exercise price discipline when buying stocks.
The Ashe study tells us why.
We start out thinking that price doesn’t matter all that much. And it truly doesn’t. Stocks offer a strong enough value proposition that they beat the other asset classes even when they are overpriced a bit. But of course our belief that price doesn’t matter rips the brakes out of the car. Small amounts of overvaluation grow larger and larger over time. Eventually prices reach bubble levels and matter a great deal indeed. Still, most of us act as if there is no problem. The peer-revewed research of the past 34 years shows that insanely overpriced stocks are very dangerous. But we keep quiet about the dangers, permitting the problem to get worse and worse.
Bull markets are the product of peer pressure. That’s what the Ashe study is telling us. We all see the dangers associated with overvaluation. It’s not intellectually hard to understand why going with a high stock allocation when stocks are priced at three times fair value (as they were in 2000) is not such a hot idea. But we don’t speak out because we see that lots of our friends and neighbors and co-workers are enjoying the high prices and counting on the pretend gains to finance their retirements. We let that peer pressure cause us to think and speak falsely about the effects of mispricing just as the Ashe study participants let the false answers given by fake study participants cause them to misidentify the line on the second card that was of the same length as the line on the first card.
It’s not that we are dumb. It’s that social approval means a great deal to us. We are willing to play dumb to avoid losing the approval of our peers. If necessary, we are willing to play dumb so effectively that we persuade ourselves that the false beliefs are sound.
I read a bit more about the Ashe study on the internet and came across an aspect of it that I overlooked in my earlier article that I find highly encouraging. The power of the false responses to pressure real study participants to give wrong answers was greatly reduced when even one of the fake study participants gave an answer at odds with the answers given by the other fake study participants.
We give in to peer pressure only when it appears sure of itself. When all of the fake study participants are saying the same wrong thing, we find it very hard to stick to our guns and report accurately what our eyes tell us to be the truth. But if just one of our peers offers a different take, we gain the confidence we need to stand up to the peer pressure ourselves.
This is consistent with my experience trying to explore the implications of Shiller’s ideas on the internet over the past 13 years. I have been surprised how the same pattern of interaction has repeated itself over and over again. When I arrive at a new discussion board or blog, I usually see a very positive reaction to my explanations of why it is so important to consider price when buying stocks. Inevitably, however, Buy-and-Holders become upset about what I am saying and become abusive in their responses. This always causes the posters who were excited by my work to get quiet and to permit the Buy-and-Holders to dominate the discussion.
Buy-and-Hold is dominant today not because it rests on strong intellectual support. It is dominant because it causes those who follow it to become insanely emotional about the merits of their favored investing strategy. We all want to invest effectively. But most of us don’t see it as a matter of life and death to be right about this stuff. The Buy-and-Holders do; I think it is because they feel doubts that they want to suppress. Once the Buy-and-Holders express strong views, those of us who have doubts about Buy-and-Hold self-censor ourselves and the effort to create a learning experience is lost.
The suggestion of the Ashe research s that we only need a small percentage of us to work up the courage to challenge the Buy-and-Hold dogmas and the rest of us will feel emboldened to express our doubts too. Peer pressure is a powerful force in stock investing. But it is a power that can be overcome quickly once a stock crash wipes out much of the life savings of millions of investors.
Rob Bennett’s bio is here.