Valuation-Informed Indexing #278

by Rob Bennett

I read an article this week that explored the differences between how we have responded as a society to the pushes for limits on smoking and on guns. The push for limits on smoking has been highly successful. The push for limits on guns has not been terribly successful. Why?

The article argued that the difference is that smoking is not an ideological or cultural issue; neither conservatives nor liberals see efforts to limit smoking as an attack on their world view. It’s different with guns. Most cities are heavily liberal and most rural areas are heavily conservative. As a result, there are strong ideological and cultural differences between those who own guns and those who do not. Those who have never been around guns have a hard time understanding why anyone would feel a need to own one. But those who have been around guns all their lives cannot understand why those favoring limits on ownership are so troubled by guns. So efforts to change the law in this area produce intense conflicts; the harder one side pushes for limits, the harder the other side opposes those limits and gridlock results.

“Bias” is not one thing. There are many varieties of biases, some more problematic than others.

In fact, an argument can be made that some biases are good. As a general rule, it is a bad thing to be biased because to possess a bias is to respond unthinkingly to a phenomenon. But acting on the basis of a bias speeds up one’s reaction time and that is not such a bad thing in some cases. I have a strong bias against disco. I have probably missed out on some disco songs from which I would have derived a pleasurable listening experience. But there aren’t many disco songs that fall into that category. And my bias helped me avoid a lot of painful listening experiences too.

The biases that many of us hold about investing issues are extremely damaging, in my view.

Most biases are phenomenon-based. We favor certain types of food over others. Or we favor certain ways of thinking about issues over others. Or we favor certain ways of doing things over others. These biases can hold us back. But the good thing about phenomenon-based biases is that we can limit the power of the bias by deliberately exposing ourselves to the opposite sort of phenomenon from time to time to check whether the bias is supported by the realities.

Liberals are biased against conservative ideas and conservatives are biased against liberal ideas. Is that really such a bad thing? If we reconsidered our philosophical orientation each time a new issue was presented to us for our assessment, it would take much longer for us to figure out where we stand on issues. The reality is that once a person has thought about a few issues hard enough to know where his bias lies, he can save time when assessing new issues by jumping to a quick conclusion that his position will be ideologically consistent with his earlier positions. Being biased is a time-saver.

But there are dangers, of course. There are always those few issues re which a liberal adopts the conservative take and those few issues re which a conservative adopts the liberal take. Those exceptions can achieve great significance over time. If you follow the story of how a liberal becomes a conservative over a number of years or of how a conservative becomes a liberal over a number of years, you will see that it is usually one important exception to a general bias that starts the ball rolling in a new direction. I often seek out views different than my own just to shake up my preconceptions a bit.

It’s very very hard to do that in the investing realm. The most important investing biases are time-based rather than phenomenon-based. That means that for long periods of time certain ideas are forgotten by almost the entire population. To tap into the other side of the story the investor would have to study historical data from a time-period many years removed from the current time-period. Who does that?

Shiller showed that valuations affect long-term returns. What he really was doing when he did that was showing that the stock market is not efficient, that mis-pricing on either the high or low side is a significant reality rather than the illusion that Buy-and-Holders believe it to be. Even during the most out-of-control bull market, there are a small number of people questioning whether the insane prices achieved are real and lasting. But the percentage of the population holding that view can be very small indeed. The percentage of the population that is conservative rather than liberal doesn’t vary dramatically from time to time. The percentage of the population that believes that stocks are the perfect investment choice is dramatically higher when prices are high than it is when prices are low.

For a good number of years following the great crash of 1929, investors didn’t expect to see any capital appreciation at all on their stocks. The conventional wisdom of the time was that stocks were worth buying only for their dividends; those that didn’t pay high dividends were not worth owning. In the late 1990s, dividends fell to tiny levels. The very thing that made stocks dangerous (their high price) changed the conventional wisdom on stock ownership to reflect a bias that stocks are always worth owning.

Stocks for the Long Run was a popular book in the 1990s. It would not have sold many copies in the 1930s. The book reports on data, facts, objective stuff. The message of the data should not change from times like the 1930s to times like the 1990s. But the ways in which we arrange the data and interpret the data changes when we go from bull markets to bear markets. People will be looking at the same data that was employed in Stocks for the Long Run to sell stocks to make the case against stocks when we are on the other side of the next stock crash.

Our stock biases hurt us. But they are hard to see through because just about everyone is on one side of the table for a long stretch of time and then just about everyone is on the other side of the table for the next long stretch of time. Bull markets turn us all into bulls and bear markets turn us all into bears. Investing biases come to be so widely shared for long stretches of time that it is hard for any of us to keep their other point of view even remotely in mind.

Rob Bennett’s bio is here.