Stock investors are emotional.
Not a little bit. A lot.
Today’s CAPE value is 30. The CAPE value could never reach 30 if stock investors were not crazy emotional creatures. The fair-value CAPE level is 17. So stocks are today priced at nearly two times their real value.
It’s hard to let in how much harm we have done to ourselves by permitting the CAPE value to rise so high. Not by making a rational choice to do so. By following our emotions where they led us.
Q2 2022 hedge fund letters, conferences and more
Keeping Emotions Under Control
Keeping our emotions (and thus stock prices) under control should be really easy. All that we would need to do would be to remind ourselves how much damage we do to ourselves when we permit stock prices to get too high. That would scare us straight.
But you know how it goes. The humans know how much damage it does to drink to excess and how much damage it does to gamble to excess and how much damage it does to get involved romantically with people who have all sorts of red flags waving around them and they still do it. In a battle between emotion and reason, emotion often prevails.
It’s not always that way, however. I don’t believe that we are doomed. Lots of people do not drink to excess, lots of people do not gamble to excess, lots of people pay attention to the red flags and avoid excessive drama in their romantic relationships.
If rationality can prevail in these other realms of human behavior, why does it seem like it never will in the stock investing realm?
There’s a lack of awareness of the emotion problem in the stock investing realm. We have this academic construct in the stock investing realm called “the Efficient Market Hypothesis” that assumes that investors are 100 percent rational and, because the people who advanced the hypothesis are generally very smart people. The rest of us have been reluctant to challenge their assumption for a long, long time.
And as the evidence has poured in that the assumption is entirely opposite to the reality of the situation, we have grown even more reluctant to point out the error, permitting it to harden into a widely accepted truth.
The more the evidence accumulated that the market is anything but efficient and the investors who make it up are anything but rational, the harder it became to point out that the Buy-and-Hold Emperor is wearing no clothes.
But I do not believe that we are doomed.
Emotional Investing
There are a lot of things that we can do to become more rational investors once we overcome the first hurdle, accepting that there is a problem. That’s the biggie.
Tell a Buy-and-Holder that he is investing emotionally because he fails to engage in market timing (which is the means by which we exercise price discipline when buying stocks) and he will tear your head off. “I am not capable of emotion! Not even a tiny bit!” he will hollar, banging the table for emphasis. What can you say to that sort of reaction?
But that’s only the first step. Getting the Buy-and-Holders to acknowledge that they are human and that therefore they are capable of acting on emotion is really, really, really hard. But once we get past that step, there are all sorts of wonderful, constructive things that we can do to make ourselves less emotional (and therefore more successful) stock investors.
I like to tie things to the safe withdrawal rate issue because that is the issue that got me started on the path that I walk today.
The Buy-and-Holders say that the safe withdrawal rate is always 4 percent. Incorporate valuations into your analysis and you learn that the safe withdrawal rate can drop to as low as 1.6 percent (when stocks are priced as they were in 2000) and can rise to as high as 9.0 (when stocks are priced as they were in 1982). That’s an amazing difference.
If stocks offered a real return of zero for 30 years, the safe withdrawal rate would be 3.3 percent. Think what it means about how dangerous stocks become when they are insanely overpriced that the math shows that the safe withdrawal rate can drop to 1.6 percent, less than half of the zero-return safe withdrawal rate!
Here’s something that I look forward to. If (when!) we get to a point where we are freely discussing the amazing how-to implications of Shiller’s Nobel-prize-winning research at every investing site on the internet.
We will no longer hear reports of how stock prices have changed over the course of the day without also hearing whether the price increases represent a real and lasting added value or whether they are just the product of irrational exuberance. That’s going to bring on a huge advance in our understanding of how stock investing works. And it’s not far away.
Intellectually, we are there today. The thing that has been holding us back for 41 years and that is still holding us back today is that we humans don’t like thinking about how emotional we can sometimes be. To overcome a problem, you first need to acknowledge that it exists. The alcoholic often does not seek help until he is lying face first in the gutter.
Rob’s bio is here.
