The Frontal Cortex

Bubbles

Posted by Jonah Lehrer on February 25, 2009
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In case you were wondering how you should invest your retirement savings (assuming you’re fortunate enough to still have some), yet another study demonstrates that low cost index funds are the way to go:

Basic stock market index funds generally aspire to nothing more than matching the returns of a market benchmark. So in a miserable year for stocks, index funds may not look very appealing. But it turns out that, after fees and taxes, it is the extremely rare actively managed fund or hedge fund that does better than a simple index fund.

That, at least, is the finding of a new study by Mark Kritzman, president and chief executive of Windham Capital Management of Boston. He presented his results in the Feb. 1 issue of Economics & Portfolio Strategy, a newsletter for institutional investors published by Peter L. Bernstein Inc.

Why are index funds so effective? Here’s a related question: Why are most mutual funds and hedge funds so ineffective? The answer, I think, gets back to our mistaken belief that the market can be beat in the first place:

Think about the stock market, which is a classic example of a “random walk,” since the past movement of any particular stock cannot be used to predict its future movement. The inherent randomness of the market was first proposed by the economist Eugene Fama, in the early 1960′s. Fama looked at decades of stock market data in order to prove that no amount of knowledge or rational analysis could help you figure out what would happen next. All of the esoteric tools used by investors to make sense of the market were pure nonsense. Wall Street was like a slot machine.

The danger of the stock market, however, is that sometimes its erratic fluctuations can actually look predictable, at least in the short-term. Our brain is determined to solve the flux, but most of the time there is nothing to solve. And so our we flail against the stochasticity, searching for lucrative patterns. Instead of seeing the randomness, we naturally come up with explanations to explain it away. We see meaningful trends where there are only meaningless streaks. “People enjoy investing in the market and gambling in a casino for the same reason that they see Snoopy in the clouds,” says Read Montague. “When the brain is exposed to anything random, like a slot machine or the shape of a cloud, it automatically imposes a pattern onto the noise. But that isn’t Snoopy, and you haven’t found the secret pattern in the stock market.”

I recently wrote an article for the London Times in which I confessed my own investing errors and discussed some recent research into why financial bubbles are such a recurring theme of economic history:

I am a sucker for financial bubbles. The first stock I bought was Cisco Systems, in early 2000. It was the height of the dot-com bubble and Cisco was about to become the most valuable company in the world. Naturally my investment crashed too.

I’d like to say that I learnt from my dot-com disaster, but I didn’t. In late 2006 I began investing in blue-chip financial stocks, such as Citibank and Bank of America. At the time these companies were reporting record profits as they expanded into the sub-prime mortgage business. We all know how that turned out.

If there’s any consolation from my losses it’s that I wasn’t the only one. The current economic crisis is a by-product of collective failure, an example of terrible decision-making on a huge scale. Banks gave out loans to people who shouldn’t have taken them, consumers got used to spending money they didn’t have, regulators failed to regulate, and investors, appeased by ephemeral profits, failed to ask hard questions.

In retrospect we can see the profound foolishness of this behaviour. Yet it’s worth remembering that this is not the first time that the markets have gone haywire. The history of finance is largely a history of financial bubbles, from the tulip mania of 17th-century Holland to the South Sea Bubble of 18th-century England. Do we never learn? And, if not, why not?

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Comments

  1. #1 Eric Lund
    February 25, 2009

    after fees and taxes

    That is the key point. By definition the net return of the average investor will be the market return less investment expenses. So in general, minimizing expenses is the way to go. The standard 2-and-20 fee structure of hedge funds is basically a license for the hedge fund operator to print money.

    There are some traders who can, over the short run, beat the market averages. They are vastly outnumbered by those who believe, incorrectly, that they can do so. And even those in the former category are subject to mean reversion.

    Some would argue that investing in stocks in general is a bad move at this time, and there is a case to be made for this viewpoint. But if you are going to invest in stocks anyway, and you don’t have both the time and the skill to day-trade, index funds are definitely the way to go.

  2. #2 Kelly
    February 25, 2009

    Perhaps all investments articles should be in the Entertainment section.

    Some of the attraction of expensive hedge funds and such is a mistaken notion that you get what you pay for. Fund fees may be another random phenomena were trying to force into a logical structure.

  3. #3 david jobson
    February 25, 2009

    This comment doesn’t pertain to the current blog entry, but I have just come across the Moral Mind chapter of your book How we Decide.

    This chapter is a huge let down. Morality and ethics are a rather complicated subject to deal with and to often conflate the two notions is unexcusable.

    Furhter, from what I understand from some psychologists, psychopathic people are indeed rather emotional – getting exciteed, nervous, angry etc… Do you really think that psychopaths have no emotions?

    And since this chapter is based on brain research of psychopaths, the whole chapter is fundamentally flawed. I mean, i just stopped reading it. It became over-simplified and stupid and sick. For example, the wqay you dealt with the incest scenario is just a disgusting.

    You simply have little understanding of some of the subject matter you are writing about. Ever taken an ethics course? Ever had a girlfriend who was a victim of incest?

    I would discourage anybody from reading what you write.

  4. #4 david jobson
    February 26, 2009

    Looking at the author photo in the book it now makes sense to me. You are supposed to be like the hip philosopher. So hip that he doesn’t even have to spend more than a paragraph on what is ethics. All you editor has to see is that you demonstrate that you know more than what the average college graduate would.

    I feel that you are full of crap – a charlatan.

  5. #5 Tom Luce
    February 26, 2009

    Jonah,

    I read your book and greatly enjoyed it, so I have been checking your blog lately and found this post on Bubbles particularly interesting. So I asked my financial adviser to read it and give me his take. I’m pasting his response in below. I’d be interested in your thoughts. Thanks again for a great book.

    “I have hashed and re-hashed arguments like Lehrer’s since I began my investing career. I do disagree, in general, as you predicted. Several important items of disagreement:

    1) Stock returns are not a “random walk”. It is only a small number of selectively chosen studies that makes it seem that they are. I could go into some of the misunderstandings of math, randomness and the normal distribution that cause researchers to believe in randomness. But that would take a long time. Suffice it to say that I have a degree in math.
    2) For example, the beginning valuation of a stock has a strong correlation with its future long-term return. The lower the valuation, the higher the return. For any particular stock, an investor’s confidence can not be high, but, in the aggregate, the correlation relationship is ‘sticky’… it can’t be explained away by randomness.
    3) The point about dopamine receptors is well taken. I don’t have a degree in biochemistry, but I believe the author’s conclusion is reasonable, and reasonably well supported. Indeed, it is the very existence of such irrational herd behavior that creates opportunities for rational investors. Without behavior that is, in the aggregate, occasionally irrational, the author’s conclusion about indexing would be correct.
    4) The problem, then, becomes, how to avoid the irrational behavior for one’s self! I do not have a gambling addiction, so I can not understand all the ins and outs of how someone with such a specific dopamine problem might seek to do this. However, I do know that my “natural reaction” to a gain is never to buy more. My “first impulse” after a loss is to buy more… I then go back and re-work my research to make sure it is right. I set my own position sizes not based on how I feel, but based on very specific rules I have set for myself, having to do with a) limiting exposure to any one particular idea or set of ideas, and b) having more exposure to the ideas with the best numbers behind them, not necessarily the most “conviction” behind them. All this tells me that I am not especially subject to the dopamine feedback loops discussed by Lehrer.

    Again, this is an age-old discussion. You and I won’t solve it. Just don’t set up passive management in your mind on one side, while on the other side is a set of silly investing behaviors like Lehrer describes. It’s not like that: all or nothing. Also, keep in mind that, if someone decides to go passive, that person still has to decide how, right? The “wrong way” can end up losing you money just as certainly as a foolish approach to active investing, yes? Also, you will be just as tempted to “play with” your passive approach once you’ve set it, perhaps adding an asset class here, or changing a weighting there. If you believe in the dopamine theory, won’t you be likely to make these changes at precisely the wrong times, and for precisely the wrong reasons? Food for thought…

  6. #6 Art
    February 26, 2009

    david jobson said: “I would discourage anybody from reading what you write.”

    Geee, now I have to go out and buy this guys book just to see what would so motivate someone to enter into a thread completely unrelated to what he wants to talk about and make such a broad statement. It must be really gripping stuff.

    What, you couldn’t find a review of said book to unload your bile onto? You couldn’t just say the book has ‘problems’ or one particular chapter is really bad? Instead you condemn the entire book based on a simple disagreement about one chapter and then, as if that were not ridiculous enough, go on to condemn everything written by this guy. Wow. You sound like the type who burns down a house because one of the doors squeaks.

    Without having read the book, I haven’t purchased it yet, I can’t imagine how one bad book, much less one bad chapter, could invalidate the entire written record of a person. This sort of sounds like a personal problem. Jealousy? Or perhaps he struck a little too close to home and your just a little too sensitive. And taking it all far too personally.

    Now let’s see, where can I buy this book? Ah, yes, Amazon has served well in the past:
    http://www.amazon.com/How-We-Decide-Jonah-Lehrer/dp/0618620117

    “$16.50 & eligible for FREE Super Saver Shipping” cool deal.

  7. #7 Bob
    February 28, 2009

    Whenever I hear a comment from someone regarding a topic like this, I first ask if where their interest lies. For example, a stockbroker would have to find other employment if more people practiced “buy and hold” using index funds because they make money from commissions. There are two wanks called Dr. Doom and The Black Swan who are arguing that things are going to get a lot worse. The main reason that the financial channels broadcast their message is to cause more stock trading for their sponsors. It remains to be seen if these guy are stopped clocks who are occasionally right (Like Elaine Garazarelli) or true prophets. If a sufficient number of us believe what they say, we will have a Depression.

    As Adam Smith said over two centuries ago in “The Wealth of Nations,” everyone’s wealth is interconnected with everyone else’s wealth. Wealth is not a fixed quantity. It expands and contracts with economy activity and governments actually less control over it than people believe. In a market economy, we are very depended upon each others’ participation. It ties in with the “Paradox of Thrift” which says that the more people try to save, the less they are able to save. When each of us spends less, we all suffer.

    The news media has used used a technique called Neuromarketing to cause fear and anger is its viewers. It does this by spinning the news content to make people’s blood boil. This increases sales for their sponsors through lowered sales resistance by their audience. A few years ago, an Emory Medical School study discovered how it works but shut down their study for ethical reasons. However, the genie is out of the bottle. Here is a link to describe how their sales tactic works.
    http://www.salesbrain.net/users/folder.asp.

  8. #8 Bob
    February 28, 2009

    In my previous post, I gave you a URL that has changed. Go to this link and click on the Why Neuromarketing? hyperlink on the left.
    http://www.salesbrain.net/

  9. #9 lee pirozzi
    February 28, 2009

    My middle son is outside digging for civil war treasures( our house was built on top of an old civil war hospital sight). Maybe he has the right idea. I would invest in stem cell research.

    And as for the interruptive outrage of hostility plastered
    in that free book review you received above, allow me to
    remember that those people who are “OKAY WITH THEMSELVES” find less need to criticize others in such a randon manner.

  10. #10 Ashley Smith
    March 1, 2009

    Well, I really enjoyed the comment of Tom Luce, “Suffice it to say that I have a degree in math.” Suffice it to say, a degree in math must then certainly give the correct answer, despite conflicting opinions from other researchers who also presumably have a degree in math or financial mathematics.

    As regards Mr. Lehrer’s last round of surmising on the Dutch tulips and similar bubbles, financial bubbles and crashes have been explored in the field of social learning and behavioral economics. There are some interesting papers floating about that delve into a) how the gambler’s fallacy or hot-hand fallacy both play into financial investments and b) informational cascades (separate from the concept of herd behavior via the fragility of shifts in the cascade) account for large, sudden shifts in trends and how signals of previous actors in a sequential decision chain can override private signals.

  11. #11 Urstoff
    March 1, 2009

    The Efficient Market Hypothesis strikes again! Of course, we must modify efficient to mean not genuine efficiency, but what everyone thinks is efficient.

  12. #12 Paul McEnany
    March 1, 2009

    wait a minute…the brits got their own book name? I want that version. It might be even smarter with a british accent.

  13. #13 Martyn Strong
    March 2, 2009

    Capital markets are unstable. In the past there was no way to make them stable. But today we have computer power that can be used to make them stable. By using the greater computer power of today we can have a much higher turn over of capital in the capital market. This higher turnover will make the market harder to game or control and the market will no longer have the unstable run ups or declines. Who can change or control the market when say 20% of the capital is trading each day? So now that we have the compute power to provide for all these transactions that will smooth out the market how do we force people to turn over at a rate of 20% a day? Easy, put a cap gains tax of 0% (zero) on all gains of 7 days or less and put a cap gains tax of 90% of all gains of more than 7 days. The likes of Yahoo, Micosoft and/or Sun Micro Systems will give us the systems that will provide automated software agents to support turning over one’s investments every 7 days (based on the specs you give the agent). A system like this will make the financial markets work as smoothly as the local fruit market.

  14. #14 johno
    March 11, 2009

    @Martyn Stron, wow, that sounds…really insane and really neat.

  15. #15 Kurtalan
    March 11, 2009

    Thanks Your..

  16. #16 matt
    March 16, 2009

    Sector focused ETFs seem better than Index funds, but a few questions.

    If most investors invested in index funds, wouldn’t it distort the value of the market? If you invest in an S&P 500 index fund, it’s equivalent using a central planning committee to pick the top 500 companies. Even if they are right, the extra money flooding into the fund means the 500th company will be overvalued and the the 501st company will then be undervalued. The whole point of company valuation by market share price will be undermined.

    Second, diversification means buying more than stocks. For me this means corporate bonds, government bonds, currencies, commodities, precious metals, real estate, and CDs. With a really diversified strategy, things tend to balance out. In reality, I am also heavily invested in my own enterprise, but I try to put much of my profits into other investments.

    The key is watching for bubbles. When it looks like there is a bubble, I get out of one of those sectors for a while. The real estate bubble went on far longer than it should have. I got out in 2005. The oil bubble of the summer allowed me to get out of oil for about six months until late December. This is why general index funds don’t work for me, and I prefer sector based funds. I have ETFs that track financial companies, foreign companies, etc. If you see a speculative bubble developing in one of those areas, you can slip out.