The Big Investment Lie

The herding instinct

A good quote channeled from the late economist John Maynard Keynes by his student, the less-late Hyman Minsky -- of whom we hear a lot recently and can expect to hear more -- is offered by Martin Wolf in his Financial Times column:

“A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.”

What are the right probabilities?

I like to use probabilities to give investors a sense of what might happen in the future. For example, I might tell them there's a 50% chance that if they deploy a particular investment strategy they'll have at least $1 million in 20 years and a 20% chance they'll have at least $3 million, but a 2% chance they'll have no more than $500,000.

Two questions must be asked: First, what model should be used to estimate those probabilities? And second, do people understand what they mean?

Blogger Michael Graham Richard hosts an interesting discussion of how these two questions relate to each other. It's often thought that people (read, "laymen") overestimate probabilities of unlikely events. Experts, on the other hand, can calculate them objectively. For example, experts calculate probabilities of nuclear power accidents by tracing through every possible event tree, estimating its small probability and adding these small probabilities together. Laymen, on the other hand, see how many things can go wrong, and panic, overestimating the resulting probability.

Who's right, the experts or the laymen? Nuclear power risks are totally different from investing risks. But in investing, we have clearly seen that the experts get it wrong, time and time again. How often have we heard that an "expert" said, "This event [which actually happened] had only a one-in-a-trillion chance of occurring"?

The problem is that "experts" depend only on "objective" information -- that is, on a limited quantity of historical data. This includes -- to use Donald Rumsfeld's famous formulation -- only the "known unknowns" (or at least the known level of uncertainty found in relatively recent history), but not the "unknown unknowns", that is, the uncertainties that cannot be calculated from recent history.

So in investing -- if not necessarily in nuclear power -- experts' estimates of risks need to be almost totally ignored, because their methodology is fatally flawed.

That said, I do believe that probabilities of investment results can be estimated realistically, but certainly not by using the methods that experts have been using.

Never again?

Some strong words are being written about the financial crisis.

For example, an article by Will Hutton in the Manchester Guardian, a British weekly, subtitled, "A lethal new threat is emerging at the dark heart of the world's financial system," ends with this paragraph:

"For 30 years, greedy, callow, ignorant financiers, supported by no less callow politicians from all parties, have proclaimed the wonders of financial innovation. The price tag for their behaviour is an economic calamity. We should never have bought such snake oil. The consolation in these dark times is that we never will again."

We never will again?

That's not so certain. Like wars -- for which similar blame can be laid -- financial crises keep recurring. Perhaps better is to expect them, and best yet to do it in a jovial vein, like Galbraith in his "bezzle" explanation of the Crash of 1929.

Should you own your home?

In the United States it's an article of faith, almost of patriotism that to be a real citizen you should own your own home.

But stripped of the sentimental factor, it's only an investment decision, subject to the usual rules of risk and return. Home ownership is often touted as the best investment you can make -- and that's often true -- but it's also a risky investment.

The reason it's a good investment is that it's so highly leveraged (you borrow most of the money to buy a house) -- and because the loan you get to buy your house is subsidized by the government (you get a tax deduction for the interest) -- but that's also why it's a highly risky investment.

Now we've seen how risky it can be. As measured by the Case-Shiller home price index, prices of single-family homes in 20 major cities dropped by 15.3% in April (but only to 2004 levels). If you bought a house at the peak with a 90% mortgage, you've lost 150 percent of your investment.

New York Times columnist Paul Krugman recently asked if home ownership should be a policy goal ("Home Not-So-Sweet Home"). You should also consider whether it makes sense as part of your investment portfolio, which is exactly what it most certainly is. If there's even a whiff of a bubble under way, it's probably too risky a time to buy.

This shows again how difficult it is to keep sentiment out of it when making rational investment decisions.

Don't fight with a spouse on a diet

The sharp recent growth in food prices has not gone unnoticed in the US, and is a serious concern in countries where there's not enough disposable income to buffer the increased spending on necessary goods.  The saying "a hungry mob in an angry mob" has never been mentioned this much.

Now we have a proven scientific explanation.  Hunger causes a fall in serotonin (whose main chemical precursor, tryptophan, is found abundantly in comfort foods such as chicken soup and chocolate).  Researchers at Cambridge University have shown that serotonin plays a critical role in keeping aggressive responses in check.

From Science Express, via the Financial Times.

Are you making mistakes investing in your 401(k)?

The Federal Reserve Bank of San Francisco puts out periodic Economic Letters on topics of interest in the economy. The latest is "Retirement Savings and Decision Errors: Lessons from Behavioral Economics". It focuses on the errors people make in investing in their 401(k) plans, particularly in failing to contribute enough to them because of procrastination, laziness about making decisions, and so on.

What the Letter doesn't mention, as usual, is that it's not always rational to invest in your 401(k). In fact it's often not rational.

We pointed out in an earlier entry that the fees charged by 401(k)s typically start to exceed your employer's match when you're in your 30s. Later they can easily exceed the sum of your employer's match and your contribution. Both you and your employer will be paying in only to cover the fees, not to add to your retirement savings.

We calculate that it doesn't make sense to invest in your 401(k) if the fees it charges you are more than 1.7% or 1.8% annually. It's hard to find out what that percentage actually is (surprise!) but if you can, and if it's more than that, use your own IRA and taxable accounts instead.

Saving for retirement is like a muscle

Psychologist Cordelia Fine's "A Mind of Its Own - How Your Brain Distorts and Deceives" is a short and very entertaining trip through different facets of the human brain.  One of them - the weak-willed brain - is of particular relevance to saving and investing.

According to several studies reviewed by Fine, our ability to make unpleasant but good-for-you decisions (like dieting or saving money) is like a muscle in two different ways.  First of all, it gets stronger with regular exercise. Test subjects have shown a significant increase in willpower after putting it to work for a while. However, like a muscle, it loses strength if overused in a short period of time. After a whole day of healthy eating it is easier to fall for that triple-layer chocolate cake at dinner. Therefore a trick is to avoid having to make these painful decisions as much as possible: if exercising is built into your morning routine, you don't "decide" whether to do it or not - you just do it.

Saving for retirement is another of these unpleasant but good-for-you-in-the-long-term decisions. So here is what you have to do:

• save regularly and often (strengthen your muscle), and
• put away a fixed amount of money with every paycheck (don't overwork your muscle if you don't have to).

UPDATE (4/4): It turns out that the New York Times recently ran an op-ed piece on this very topic, albeit without any reference to Fine's book. Via Guy Kawasaki's Truemors.