Two seemingly unrelated things caught my eye over the past week or so. First, a survey of investors found that two-thirds of them think putting $1,000 in the stock market (when the Dow was about 7,500) was a bad idea. Two years ago, when the market was soaring above 11,000, the same survey found the exact opposite conclusion—two-thirds thought it was a great time to invest.
If you stop and think about it, that really doesn’t make much sense. As a group, investors were more likely to buy at a time when the market was widely thought to be exhibiting “irrational existence” then at a time when it is performing well below the levels justified by economic conditions. You would think it would be just the opposite. Since when was “Buy high and sell low” a good idea?
The second event was the selection of David Kahneman, an Israeli-born psychologist now at Princeton, to share this year’s Nobel Prize in Economics. It was only the second time that someone outside the field of economics and finance has won this award (the other one, also from Princeton, was mathematician John Nash of A Beautiful Mind fame). How does a psychologist garner a Nobel in Economics, and what does that have to do with our backwards investors?
Going back to the origins of modern economics and the Western philosophical tradition on which it is based, most of our models were based on the notion that consumers and investors are rational. We certainly recognized that not everyone would be totally sensible all the time, but our friends in classical mathematics assured us that, across the whole population, these deviations would cancel one another.
Kahneman and Amos Tversky, a fellow psychologist he met as a young professional at Hebrew University in Jerusalem, began to experiment with human behavior to test our time-honored assumptions. (Tversky, who ended up at Stanford, would have no doubt shared the Nobel had he not died in 1996; you have to be alive to be eligible, which is a good reason giving many others, for economists to aspire to a long life.) They discovered that we were at times systematically irrational, that is, we consistently made the wrong decision. Armed with this knowledge, our models got better.
A few examples illustrate this point quite well. Consumers value a 2% cash discount, yet object to a 2% surcharge on the use of credit cards (even though the numbers come out exactly the same). When we need to sell stocks from our portfolio, we tend to keep the dogs and get rid of the ones that are performing well. The reason—we hate to recognize losses.
Our attitudes toward dividends (which we like) are even more bizarre. If corporations had never paid dividends, they would have 90% less debt. They could invest these funds (at an average long-term return of 12%+) or even buy back shares in the market to increase earnings per share and stock prices. If we as investors needed cash, we could sell some of this highly valuable stock and pay relatively low capital gains taxes. Instead, we reward companies for paying us dividends, even though we pay more income tax and receive an asset on which we can typically earn only 2%-4%. The survey I mentioned at the outset is but another example. Despite wisdom to the contrary, we have a measurable tendency to buy when the market is high and sell when it is low.
This pattern impacts much of our lives in other areas as well. We have fears of violent crimes and casualty losses which far exceed their likelihood of occurrence (which has spawned an entire industry). The dramatic reduction in activity in the Washington DC area recently is a case in point; the odds against being a sniper victim in a metropolitan area with millions of people are enormous. We consistently rate a 90% employment rate as good, and a 10% unemployment rate as bad (they are the same thing). I could go on and one, but you get the picture, and I am running out of my allotted space.
I certainly wouldn’t suggest that we are totally illogical beings (nor would Kahneman). After all, at the most basic level, we are the species that has survived and prospered through eons of natural selection. The lessons from these findings are simply that (1) we are not generally as rational as we like to think we are; (2) we can profit substantially from taking a moment to evaluate our actions (economic and otherwise) in this light; and (3) perhaps we have more in common with teenagers than we care to admit.