5 Theories About Investor Behavior in the Stock Market
Between my day-to-day activities working with people and my unique vantage point running what has become one of the largest and longest running investing sites on the Internet for the past (approaching) fifteen years over at Investing for Beginners, I’ve come to accept that behavioral economics is the superior model for understanding investor conduct.
When I first began writing, I truly did not understand how willingly people would throw their life savings into some ill-conceived speculation, lose everything, wait awhile, then turn around and do it, again. It took seeing it over and over for me to accept that it was not a fluke; no outlier, just human nature. I didn’t appreciate that people would spend a few months, or maybe even years, reading books and websites to suddenly consider themselves an expert, willing to make absolute statements about areas in which they knew slightly more than average but nowhere near what a professional does, nor how emotionally vested they would get in protected their ideas even if you could prove they were based upon a mathematical error or a misunderstanding of some other concept. I didn’t appreciate how much fashion plays a role in the portfolio construction process, just as is it does in clothing, hairstyles, or musical influences, with investors going from index funds to ETFs, SMAs to emerging market hedge funds, each defended with a religious-like zeal by their particular adherents.
These days, I have five working theories that I’ve come to think explain a lot of things as it pertains to investor behavior in the stock market.
Stock Market Theory 1
I think almost all mistakes as they pertain to the stock market come down to a handful of things:
- Not knowing or understanding what you own
- Not knowing or understanding the terms on which you own it
- Not knowing or understanding the owner earnings of the assets
- Not knowing or understanding how the price you paid relative to the cash flows influences your ultimate result
- Not knowing or understanding the costs, both direct and indirect, of the asset
- Not knowing or understanding the risks of the asset – liquidity risks, reputation risk, volatility risk, leverage risk, technological risk, inflation risk, political risk, et cetera
- Not knowing or understanding the tax code and how it can be used to increase the proportion of rewards that stay in your own family’s pocketbook
- Not knowing or understanding how time frames influence result measurements (anything less than 5 years is largely meaningless)
- Not knowing or understanding basic mathematics
- Not knowing or understanding logical statements, logical arguments, and argument structure
Stock Market Theory 2
It seems to take about 7 years for the typical investor involved in the stock market to forget most of the lessons of the prior collapse, repeating the same foolish errors grounded in human behavioral psychology that caused the mess in the first place. It happens because older investors die, younger investors join the workforce, and those still taking part have largely recovered the prior damage, forgetting the pain the same way an alcoholic relapses or a spendthrift starts taking out the credit card, starting the cycle all over, again.
I’ve seen a lot of chatter recently on message boards, in forums, sites like Reddit, and other places talking about “stocks being cheap” right now due to a 5% correction. I cannot sufficiently underscore how idiotic this is. Due to the unprecedented bull market over the past six years, people have forgotten that, in normal times, an investor should expect to see a 33% peak-to-trough loss of quoted market value on his or her equity holdings. That’s life. It has nothing to do with the performance of the underlying business in most cases, it’s the auction mechanism of owners buying and selling tiny ownership pieces among themselves in what amounts to a large version of eBay, Christie’s, or Sotheby’s. Only, instead of antique candlesticks or vintage decorative tins, you’re buying the right to the proportional earnings and assets of a productive enterprise. If you have, say, a $500,000 portfolio, it is perfectly in the order of things to watch it go to $330,000 in no time, with $170,000 in unrealized market losses screaming at you from the statement. Provided the businesses are good, the earnings sufficient, and the dividend or buybacks flowing, this should not be seen as a problem, it should make you excited (more on that when we discuss the effect of the Great Depression recovery period in a moment). In fact, it shouldn’t even warrant a phone call to your broker or wealth management advisor if the portfolio itself was intelligently constructed. It’s normal.
At least two or three times in your investing life, you will see a 50% or greater peak-to-trough decline in the quoted market value of your holdings. If this bothers you, don’t own stocks. You have no business owning stocks. If you need to understand the reason, go read this case study comparison examining the results of Coca-Cola and PepsiCo, especially in light of the 1987 crash.
Stock Market Theory 3
Wall Street is bound by the super power of incentive and other institutional constraints to deliver products and services that are destined to underperform after-fees, taxes, and expenses because of the first two theories. If it actually offered products and services that helped build wealth in the most efficient way, they’d go out of business because nobody would want them. Generally this comes in three forms:
- Those who overpay for services, giving up far more than they need to for the assets and service they receive
- Those who underpay for services, being penny-wise and pound foolish costing themselves much more down the road
- Those who chase performance, plowing money into long shots, what’s attractive at the moment, or any other popular asset, strategy, security, or fad
Look at the popularity of things like “3x leverage” funds among certain retail investors who don’t know what they are doing or high-cost wrap programs at regional banks with upward of 3% of assets per annum in costs over much better alternatives such as low-cost (in some cases, free) direct stock purchase plans, dividend reinvestment plans or even white-shoe private management firms such as the one the late Christopher Browne ran before he died. Chris would take a client with $5 or $10 million and build what amount to a global, directly-held, personalized mutual-fund-for-one (an oxymoron, but you get the idea) in exchange for a flat 1.25% or 1.50% of assets depending on the circumstances, which is an incredible bargain for the level of service. The tax strategy, asset protection potential, and estate planning options alone – not to mention the significant reduction in risk in the underlying portfolio itself given the emphasis on firms that could survive another Great Depression event – made the 0.64% to 0.89% excess fee over the most comparable Vanguard fund worth itself many, many times over for anyone successful enough to need to worry about those things.
Vanguard provides a similar, albeit less personalized and tax efficient, service. If you setup a $500,000 family trust fund with Vanguard, they’ll charge you a $4,500 base annual fee + a $2,500 sole or co-trustee fee + the fee on the underlying mutual funds they help you select (e.g., ranging from 0.05% to less than 1.00% depending on the specifics). By the time all is said and done, if you choose a decent mix of passive funds, including domestic and international, you’re probably going to pay, directly and indirectly, $7,850 each year for that trust, or 1.57% of assets.
For what you are getting, this is not some greek tragedy – Vanguard is being more than fair given what regional banks charge for the same thing – but I was reading someone complaining bitterly in a personal finance forum the other day about a rock-bottom 0.75% management fee as if they were getting ripped off! Once you move beyond a typical middle class family, your needs become more complex and sophisticated. Everyone likes to point out that Warren Buffett himself is leaving his second wife around $100 million with 90% in the Vanguard S&P 500 fund and 10% in cash for the last few years of her life expectancy but dishonestly (or ignorantly) ignore the fact he almost assuredly has one of the most experienced and expensive law firms in the country – Munger, Tolles & Olson LLP – or a similarly experienced top 1% person or persons serving as his trustee and that he, himself, did most of the prep work for the estate plans given that he’s one of the best financiers in history. You have to look at the all inclusive service costs of the entire investment management process. Had Buffett himself not been doing the structural work, his estate plan would have cost a hell of a lot more to execute than people seem to think. It’s a terrible cognition bias / error to think that what works for a $50,000 middle class family with a small portfolio scales to substantial wealth. It doesn’t. If you think it does, you’re going to discover very quickly how nasty life can get and probably lose it all.
Pass away, your spouse remarries then dies in a car crash? Guess what? Without paying those management, legal, and advisory fees, you don’t have a QTIP trust so your kids, grandkids, nieces, and nephews are walking, talking Cinderellas. Their step-parent just inherited the entire estate and can now leave it to that 22-year old he or she was banging as they squander your life accumulation in Vegas. You bought that boat directly, in your name, rather than setup a company to own it and lease it to you as a customer? Yeah, good luck with that when your kid gets drunk and kills someone. These things happen. A small amount upfront can save entire fortunes down the road once you become a target. I could spend all evening writing tens of thousands of words detailing different scenarios in which someone who wasn’t a financial expert on his or her own would be better off paying the Vanguard or other fee (provided it’s below 2.00% – I know some major financial institutions push 3.00% but I think it’s morally egregious unless you’re talking about relatively tiny accounts of less than $100,000). Vanguard is not trying to rip you off. In fact, you should send your trustee flowers for watching out for you at such a cheap price following your death. Include a note with it: “Dear Vanguard, thank you for charging me this 1.57% on my family’s modest trust, all inclusive. The peace of mind and efficiency you are offering is terrific.”
If you aren’t Warren Buffett and you have $100 million you’re leaving your family, you are behaving like an absolute moron if you follow the same portfolio allocation he recommended solely by itself because you have no idea the other things he put in place and what those things cost. The way, for example, he lowered his personal estate tax? Who do you think is going to setup those non-profit foundations and handle the accounting and legal work so you can provide your kids influential and well-capitalized charities to serve as their personal platforms? Look at the whole picture.
People don’t, though. I mean, read this series of comments that was gilded multiple times on Reddit, with thousands and thousands of upvotes saying what a normal person should do if he or she won millions of dollars in a lottery. While some things are right on the money, there is so much mediocre advice that sounds reasonable in there it’s terrifying; (this is going to be harsh but for the sake of honesty, I need to be blunt here even though the man or woman who wrote that might be a lovely, generous, kind person so I mean no personal or professional offense at all) sounding as if it were written by a middling-successful attorney who doesn’t actually rank among the top 1% so he or she is trying to shove his or her existing knowledge into a strategy that is entirely sub-optimal for someone with a very large net worth. Why not just say, “You know, I don’t know. Let me check with someone more experienced.”? There is no shame in that. The stuff about not paying a private bank to manage the money while simultaneously encouraging the winner to set aside money in trust for family members … yeah, good luck with that. The fee you’d pay someone like Northern Trust to manage a pile of capital you are transferring to family members in the most tax-efficient way is going to be dwarfed by the those tax savings, which will far exceed the differential between the index fund and the “underperformance” of the managed assets due to those fees (which are almost assuredly integrated as part of a comprehensive plan they craft for you in conjunction with your attorneys). Yes, it’s going to be expensive, but when viewed from a total return perspective and your goals – getting as much money, as quickly as you can, into trusts for your relatives – the ability to structure things like family limited partnerships that then use below-market fixed-rate loans and liquidity discounts to facilitate the movement of capital from one pocket to another cannot be understated. To save 1% or 2% per year, you could cost yourself exponentially more in the long-run. It’s foolish; the economic equivalent of turning down the services of a dentist so you can oil pull at the suggestion of a hippie. It probably works well enough, but it’s a poor substitute for the task as defined.
Stock Market Theory 4
These other theories, combined, will result in a new cult of thought arising from time to time to serve as a counterbalance to whatever the last major burn was. The same way early human civilizations and tribes that didn’t understand weather patterns created myths about how rain was created or what the stars were – myths that, if challenged would get you ostracized, imprisoned, or killed – certain financial dogma will become unchallenged to the point of inanity. A good example comes from a small, vocal minority of people who adhere to the philosophies of someone for whom I have tremendous respect – John Bogle. Like Christopher Browne, he has done so much for the money management industry and his investors, I think it’s an absolute travesty that he hasn’t, yet, received the Presidential Medal of Freedom; the highest civilian honor handed out by the United States Government for service to the country.
Bogle, whose work is solid, rational, and well-documented (including the flaws and concessions of the approach that we have talked about many times in the past – pointing out that the index fund is merely a mechanism through which low-cost, low-turnover, tax-efficient investing is achieved for investors who can’t run their own money and who would be tempted to try to pick stocks to beat the market rather than meet a specific objective, such as maximizing retirement income; that, though it’s far more tax efficient to own individual securities directly – and many of the richest, most successful clients at Vanguard do, passing those shares down through the family line – unless you have a big enough net worth to worry about it and the extensive experience to understand how to select those securities, it’s better to buy the index, methodology flaws and all. That’s because the index relies on other peoples’ judgements as the value of companies so, like a financial parasite of sorts, it lives off their brainpower and extracts the benefit without actually investing in specific enterprises due to a belief in the underlying value of the enterprise on a financial, social, or structural level.) It was – and is – an elegant, simple solution to the investing problem, as presented. The entire endowment of my personal charitable foundation is split among two index funds, as a matter of fact.
You could hand these people an identical portfolio of securities that perfectly represented the S&P 500, held directly in a custody account at a 0% management fee, and because it didn’t have the magic words “index fund” on the statement, they’d reject it because they quite literally can’t tell you, in most cases, which companies they own, what the rules of the index they own are, how the methodology has changed in the past, the valuation of what they own (Bogle simplifies his rate of return projections using what he shorthands as a “speculative return” component, which is really little more than a user-friendly way of projecting implied returns at a given price based upon an expected growth in the underlying earnings – none of which the type of person I’m writing about would understand) or why they don’t follow an alternative strategy such as equal-weight or non-float adjusted. It’s really quite extraordinary. Some of these folks don’t know the difference between valuation and market timing so if someone follows the same rough process in determining allocation (e.g., Bogle discouraging the acquisition of long-duration bonds over the past few years given the bond bubble in which we find ourselves), they scream “market timer! market timer!”. It’d be funny except it’s a case of the Dunning-Kruger effect.
Case in point: I was reading a piece detailing the most successful British fund managers over the past decade or longer and every one of the half-dozen comments was something about how, “It’s a lottery picking anything other than an index because, they all underperform the index except due to luck”. It’s a total bastardization and misunderstanding of John Bogle’s nuanced, intelligent research; conclusions drawn that he never wrote and that the numbers do not support because of what amounts to a word problem they don’t comprehend. (It creates a paradox of sorts, too. My first initial reaction is to correct the misconceptions but then I think, “If someone is this intellectually lazy or inexperienced, God help them because they have no business investing in anything other than an index fund. Pointing out the error could do them harm, therefore, it might be immoral.”) They truly don’t get that fund managers are not the same thing as funds (when Peter Lynch left Fidelity’s Magellan fund, could you really call it the same product without being intellectually dishonest?). If Lynch emerged from retirement to run a domestic equity fund during a market crash, yes, I’d choose him over an index fund despite my high praise for index funds, preaching their virtues for smaller investors over the past decade and a half. This is not a difficult decision. Anyone who argues otherwise doesn’t know how to calculate standard deviations or basic probabilities. (Which, again … means index funds are the best option for them. It really is a rather marvelous paradox.)
It’s the same sort of math failure you see in people who confidently say foolish things like, “it took 25 years for the stock market to recover from the 1929 crash” because the market hit a high of 381.17 in September of that year, dropped to 40.56 on July 8th of 1932, and only made it back to the previous high on November 24th, 1954. No, it didn’t. Investors who dollar cost averaged and/or reinvested their dividends broke even in around 4 years, peak-to-trough, even though the market itself was a mere fraction of its former value. Again, it’s basic math but people don’t think about basic math, especially if they can’t answer the bat and ball question correctly.
Stop and think about what would have happened if you lived through the Great Depression and bought in at the top. At the bottom in 1932, which was about as dark as it got, AT&T was yielding 12.86%, Standard Oil of California (now Chevron) was yielding 13.33%, Standard Oil of New Jersey (now ExxonMobil) was yielding 10.00%, Dow Chemical was yielding 9.09%, Monsanto Chemical was yielding 9.62%, General Mills was yielding 10.71%, National Biscuit (now Mondelez International) was yielding 14.00%, Chrysler was yielding 20.00%, General Motors was yielding 13.11%, Coca-Cola was yielding 10.14%, Colgate-Palmolive was yielding 10.00%, Procter & Gamble was yielding 11.00%, Gillette was yielding 10.00%, William Wrigley was yielding 12.00%, J.C. Penney was yielding 16.15%, Macy’s was yielding 11.77%, American Tobacco was yielding 14.63%, Reynolds Tobacco was yielding 11.11%, IBM was yielding 11.32%, and Chase National (now JPMorgan Chase) was yielding 11.84%. This was happening while the country was suffering deflation, rather than inflation so the value of each of those dividend payments was rising in real purchasing terms on top of the double-digit yields. In 1930, 1931, 1932, and 1933, your ownership kept getting bigger as a percentage of the pie; those whopping dividend yields allowing you to gobble up far more equity so that your cost basis was drug down.
Stock Market Theory 5 – The Catch-All – Final Thoughts
– Unless the United States finds an ideal workaround to by-pass the neurological quirks that cause all of this odd behavior – and, as we’ve discussed in the past, the pension (when properly regulated and fully funded) was the best mechanism to achieve this as it divorced effort, skill, and loyalty from capital allocation skills so a guy who was otherwise a virtuous, diligent person but terrible with money or who had no interest in finance can sleep well at night knowing he doesn’t have to think about a 401(k) or IRA – we’re going to continue to see increases in retirement inequality to the point it might become a social problem as small decisions, especially early in life, lead to wildly differential outcomes due to the power of compounding.
– Even when someone comes along and devotes his or her entire life to trying to improve investor education, like John Bogle, a significant minority of people are going to engage in something known as “greedy reductionism”, reducing the key lessons to gross oversimplifications without any understanding of the underlying phenomenon or nuance, eventually leading to the same sub-optimality – maybe not today, maybe not tomorrow, maybe not next year – that they were railing against in the first place. As the old, oft-quoted Wall Street adage goes, “What wise men do in the beginning, fools do in the end”.
– There is no greater teacher for some people than significant, painful losses. For still others, not even this will deter their follies into economic self-destruction.
– Most of the time, it is a waste of effort to attempt to engage in conversation about things people don’t understand. The same reason we have click-bait infotainment on websites like CNN, demonstrating the fall of once great journalism standards, folks want easy-to-digest maxims that make up in pithiness what they lack in accuracy.
– It’s hard not to care about these things if you care about people and want what is best for them but you cannot care more about their own well-being than they do themselves unless you want to walk around a perpetual martyr.
– The twin temptations of non-restrained greed and non-controlled fear really do explain a lot.
– People want false certainty and will pay for it. Nobody wants to hear that their investments will decline by 33% in any given 36 month period based on ordinary past experience – the same past experience that made generations of investors offensively, exceedingly rich. They want their ears tickled.
– A respectable percentage of investors will not stick with a strategy through thick and thin, even when the mathematics are demonstrably in its favor. I was horrified to watch how many investors on sites like Bogleheads were 100% equity when it wasn’t appropriate for their situation prior to the 2008-2009 collapse. Then, when the world fell apart, they all but disappeared, finally cashing in when they saw 2/3rds of their portfolio vanish in a puff of smoke even though it was a temporary fluctuation; a mere blip that was meaningless in the long-run except to accumulate more. The older, wiser message board posters who would point out this folly due to having lived through challenging periods during times like the 1970’s, were decried; told they were wrong or overly cautious.
– The people who most need to read this won’t. (Even if they were somehow open to it, we now live in a world where information is determined based on search engine rankings that encourage short-term thinking and page views rather than reflection.)
Welcome to the do-it-yourself economy. The older I get, the more dangerous I think it is, especially from a social and political standpoint.