by David Dreman
Notably, one of the precursors to actual inflation is the movement in the price of gold. From late October 2008 to the end of August 2011 the price of gold rose $1,117, or 156 percent. Oil and commodity prices have also surged ahead during this same period of time: oil by 42 percent, copper by 149 percent, wheat by 54 percent. The world is awash in currency, with the likelihood that the printing presses will continue 24/7 for months to come, if not longer.
What should the smart investor do? First, not what many frightened investors have been doing: selling their stocks and putting the proceeds into Treasuries or bank accounts. In fact, that’s the last thing any knowledgeable investor should do today. We have seen how bonds and T-bills outpaced those investments in the period following 1945. With the lowest interest rates since the Great Depression, this is almost undoubtedly going to happen again and hurt large numbers of investors. After 2007–2008, it’s like jumping from the frying pan into the fire. Moving heavily into Treasuries or other bonds will seriously compound the damage to portfolios.
During the Great Depression, the deflationary environment protected and increased bond prices until World War II. The situation today is very different. With the rekindling of inflation and a low to almost zero interest rate on Treasuries, the probability of sharp losses to Treasuries, T-bills, and other fixed-income securities—as chapter 14 demonstrated—is high; just how high, we’ll see shortly.
I believe we are likely to have a period of very high inflation, possibly as bad as what the nation went through from 1978 through 1982, because of the enormous increase in our money supply since 2008. Printing money is also not likely to stimulate the economy because interest rates on the short end are already touching zero. This appears again to be the typical questionable decision making we’ve seen from the Federal Reserve in recent decades. Strong opposition exists to the Federal Reserve’s buying back Treasuries and, in the process, borrowing more money, in the face of strong criticism from most of our major trading partners. These include not only the Chinese and Russians but also the European Union, particularly Germany and the United Kingdom. Brazil and other emerging economies also fear that by loosening credit the Fed could cause new destabilizing asset bubbles abroad.18
The international fear is that this is a blatant attempt by the Fed to weaken the dollar, thereby improving our exports and decreasing our imports. In the process it can cause higher U.S. inflation and, if other countries follow by printing even more money, higher inflation globally.19 Given this situation, if we had only one trading partner, China, this might be a tool to lower our trade deficit with it, but with well over a hundred trading partners, it is a very dangerous tactic and one that is unlikely to succeed. The outcome would be only more virulent inflation.
In 1978–1982, prices rose at an almost unprecedented 9 percent annual rate. At their worst, long-term Treasuries yielded as much as 15 percent while short-term rates touched 17 percent. To take a worst case, let’s assume that the 1978–1982 rate of inflation is repeated and bond yields duplicate those back then. Investors owning a thirty-year Treasury today would see the interest rate rise from 2.9 percent (the September 2011 level) to 15 percent. Treasuries would drop 63 percent, including interest received. But inflation would gobble up another 53 percent of the bonds’ purchasing power, so that investors would have only about 17 percent of their original purchasing power left at the end of five years, and that is before taxes on the interest. As you can see again, long bonds are a disaster in this situation. Remember, the shorter the maturity, the less you lose if inflation becomes virulent.
If you agree with this analysis, stay with the recommendations of chapter 14. Stocks will do perfectly well, as they always have done. Studies show that they do well even in periods of hyperinflation. Some years back, Jeremy Siegel, the author of the excellent book Stocks for the Long Run, sent me a number of charts, at my request, of how stocks performed in periods of hyperinflation, from the Weimar Republic in Germany in the 1920s to inflation in post–World War II Brazil and Argentina. The purchasing power of those countries’ currencies was as little as one-billionth of what it had been previously. Remarkably, in all three cases, after an initial decline for some months, the indices not only adjusted for inflation but also performed considerably better, in line with the Dow and other indices in major industrial countries.
In a depressed market, such as the one we’re still in today, we don’t have to hit a home run each time at bat. We will do very well by investing in a market index fund. If you believe that contrarian strategies do work over time, you will get significantly higher returns by buying a large, diversified portfolio of contrarian stocks, as chapters 11 and 12 showed, providing much higher returns than the market for decades. Real estate and art are also good hedges for the period I believe we are about to enter, but you have to know what you’re doing. Gold will protect you against inflation but will not give you the significantly higher returns that stocks offer over time.
We’ve come a long way in sixteen chapters. Yes, it is a very different investment world out there today, and it is likely to continue to be difficult for some years to come. But it is not a world without major opportunities. Benjamin Graham used the following epigraph in his book Security Analysis, published in 1934, near the bottom of the Great Depression: “Many shall be restored that now are fallen, and many shall fall that are now in honor” (Horace, Ars Poetica, 18 B.C.).20 And so it has always been and will be again.
We have come through a terrifying period, but our system, though banged up, is still intact. And it will recover. The financial damage has been great, but our institutions and our democracy are still very much in place.
Looking back at the Great Depression of the 1930s, now almost eighty years ago, we see a period when the social fabric of the country was severely torn. The U.S. system was sharply criticized by anarchists, Communists, and large numbers of average people, including many thousands of World War I soldiers, who, after having given their all, marched on Washington in 1932 because they believed the country had abandoned them in their destitution. Joseph Kennedy, fearing the dangerous mood at the time and fearing major change in our system, allegedly said he would give up half his wealth in order to be assured his family could enjoy the other half in peace and safety.21 We are in difficult times today, but we have faced far worse throughout our history.
The tools that we have discussed in this book, almost all based on modern psychology, have worked and, unless human nature changes, should continue to work well in the years ahead. Remember, too, that this is a whole new set of tools that have not been tried by many, partly because of a lack of knowledge of their existence, partly because they have been frowned on by the prevailing academic theory, but mostly because they are psychological. It is hard to stay independent of the acknowledged best thinking of the day, even harder to avoid the strong tug of Affect, neuropsychology, overconfidence, and the plethora of other similar forces that will push at you to go the other way. These forces get to us all at one time or another. As much as I’ve studied them, they still creep up on me more than I’d like to think.
But if we can know them for what they are, we can not only escape the major damage they can inflict but also harness it. That’s the implicit goal of the strategies in this book and the likely result based on all the evidence, research, analysis, investing experience, and sheer hours of sweating the day-to-day technicalities of this new path in markets. Solid contrarian investments, soundly selected and managed, could put us all well ahead.
Good luck to those of you who are willing to try the new psychological way. And good fortune.
ACKNOWLEDGMENTS
THIS BOOK HAS its origins in two camps that have been warring with each other for well over a century. Each has an enormous number of outstanding scholars and other experts on its side, has been rewarded numerous Nobel Prizes, and quite naturally believes that its theories, well defined and well documented scientifically, are the only ones that explain economic and f
inancial behavior correctly. The first camp I am speaking of is that of the economists and financial experts who strongly believe we act with complete rationality in our economic and investment decisions. The second camp is that of the behavioralists, who state that while we can and do act rationally much of the time, we also deviate from this behavior fairly frequently. As luck would have it, from my earliest days on I had a foot in each camp.
My father was a commodities trader and investor who took me to visit the commodity pits starting when I was three. Although he was financially trained, he believed that psychology played a major role in our decisions and continually pointed out why. Naturally, I was influenced by this thinking and found merit in it from the time I was in college to the present.
Over the past several decades, I have been privileged to exchange ideas with many outstanding financial thinkers, including the late Jim Michaels at Forbes and Alan Abelson at Barron’s, as well as large numbers of outstanding investors across the country. I have had the pleasure of many long discussions over time on both financial and behavioral finance with both Arnie Wood, the chairman of Martingale Investments, and Brian Bruce, the editor of The Journal of Behavioral Finance and the chairman of Hillcrest Asset Management. Both are avid behavioralists, as well as highly sophisticated investment thinkers.
On the behavioral side, I am privileged to be acquainted with many of the leading figures studying the psychology of markets. I have known and learned a good deal of behavioral psychology from Paul Slovic, whom I have exchanged ideas with for over thirty years, and was honored to coauthor a number of academic articles with, as well as the late Amos Tversky, one of the founders of the field.
In writing this book I have had the very good fortune in working with two people who were not only highly experienced in both investments and behavioral finance but were excellent researchers as well. I owe an enormous debt to Jason Altman, CFA and excellent senior money manager and analyst, who did an outstanding job researching important aspects of this work. I also am indebted to Dr. Vladimira Ilieva, a Ph.D. in behavioral finance, for her scrupulous statistical studies documenting many of the important findings in the text, as well as for her strong research knowledge of the behavioral finance field. Finally, both Mihal Spitzer and Sarah Joyce did a terrific job of making the charts readable. To all four I owe my heartfelt thanks.
My relationship with Simon and Schuster has been a pleasant one, and I’d like to thank my editor, Emily Loose, for the enormous contributions and time that she spent on editing this work.
Naturally, any errors in the work, or what surely some readers will undoubtedly consider misguided thinking, are solely the responsibility of the author.
—David Dreman
September 30, 2011
Notes
INTRODUCTION
1. Bradley Keoun and Phil Kuntz, “Wall Street Aristocracy Got $1.2 Trillion in Secret Loans,” Businessweek, August 22, 2011.
2. J. C. Bogle, The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns (Hoboken, N.J.: Wiley, 2007), p. 81.
CHAPTER 1: PLANET OF THE BUBBLES
1. Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds (New York: Noonday, 1974), p. 55. Originally published in London in 1841 by Richard Bentley.
2. Alan Greenspan, “Economic Volatility,” remarks at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wy., August 30, 2002.
3. Virginia Cowles, The Great Swindle: The Story of the South Sea Bubble (London: Crowley Feature, 1960).
4. Mackay, Extraordinary Popular Delusions, pp. 19–20.
5. Ibid.
6. Gustave Le Bon, The Crowd (New York: Macmillan, 1896), p. 2.
7. Ibid., pp. 23–57.
CHAPTER 2: THE PERILS OF AFFECT
1. M. L. Finucane, A. Alhakami, P. Slovic, and S. M. Johnson, “The Affect Heuristic in Judgements of Risks and Benefits,” Journal of Behavioral Decision Making 13 (2000): 1–17.
2. Ibid.
3. Paul Slovic, Melissa L. Finucane, Ellen Peters, and Donald G. MacGregor, “Rational Actors or Rational Fools? Implications of the Affect Heuristic for Behavioral Economics,” in Behavioral Economics and Neoclassical Economics: Continuity or Discontinuity? Sponsored by the American Institute for Economic Research, Great Barrington, Mass., July 19–21, 2002. This paper is a revised version of Paul Slovic, Melissa Finucane, Ellen Peters, and Donald G. MacGregor, “The Affect Heuristic,” in Heuristics and Biases: The Psychology of Intuitive Judgment, ed. T. Gilovich, D. Griffin, and D. Kahneman (New York: Cambridge University Press, 2002), pp. 397–420. An earlier version of this paper was published in Journal of Socio-Economics 31, No. 5 (2002): 329–342.
4. S. Epstein, “Integration of the Cognitive and Psychodynamic Unconscious,” American Psychologist 49 (1994): 710.
5. Slovic et al., “Rational Actors or Rational Fools?” p. 17.
6. Ibid., p. 13.
7. G. F. Loewenstein, E. U. Weber, C. K. Hsee, and E. S. Welch, “Risk as Feelings,” Psychological Bulletin 127 (2001): 267–286.
8. Robert J. Shiller, “Initial Public Offerings: Investor Behavior and Underpricing,” Yale University, September 24, 1989. Photocopied.
9. Y. Rottenstreich and C. K. Hsee, “Money, Kisses and Electric Shocks: On the Affective Psychology of Risk,” Psychological Science 12 (2001): 185–190.
10. B. Fischhoff, P. Slovic, S. Lichtenstein, and B. Coombs, “How Safe Is Safe Enough? A Psychometric Study of Attitudes Towards Technological Risks and Benefits,” Policy Sciences 9 (1978): 127–152.
11. P. Slovic, D. G. MacGregor, T. Malmfors, and I. F. H. Purchase, Influence of Affective Processes on Toxicologists’ Judgements of Risk. Report No. 99-2 (Eugene, Ore.: Decision Research, 1999).
12. Slovic et al., “Rational Actors or Rational Fools?” p. 17.
13. A. S. Alhakami and P. Slovic, “A Psychological Study of the Inverse Relationship Between Perceived Risk and Perceived Benefit,” Risk Analysis 14, No. 6 (1994): 1085–1096.
14. Y. Ganzach, “Judging Risk and Return of Financial Assets,” Organizational Behavior and Human Decision Processes 83 (2001): 353–370.
15. D. T. Gilbert, E. C. Pinel, T. D. Wilson, S. J. Blumberg, and T. P. Wheatley, “Immune Neglect: A Source of Durability Bias in Affective Forecasting,” Journal of Personality and Social Psychology 75 (1998): 617–638.
16. Y. Trope and N. Liberman, “Temporal Construal and Time-Dependent Changes in Preference,” Journal of Personality and Social Psychology 79 (2000): 876–889. Y. Trope and N. Liberman, Temporal Construal (New York: New York University, Department of Psychology, 2001).
17. D. Dreman, S. Johnson, D. MacGregor, and P. Slovic, “A Report on the March 2001 Investor Sentiment Survey,” Journal of Psychology and Financial Markets 2 (2001): 126–134.
18. Slovic et al., “The Affect Heuristic.”
19. Sidney Cottle, Roger F. Murray, and Frank E. Block, Graham and Dodd’s Security Analysis, 5th ed. (New York: McGraw-Hill, 1988).
CHAPTER 3: TREACHEROUS SHORTCUTS IN DECISION MAKING
1. Scott Plous, Psychology of Judgment and Decision Making (New York: McGraw-Hill, 1993).
2. “Death Odds,” Newsweek, September 24, 1990, p. 10.
3. Jaws. Zanuck/Brown Productions Universal Pictures, 1975.
4. Amos Tversky and Daniel Kahneman, “Judgments Under Uncertainty: Heuristics and Biases,” Science 185 (1974): 1124–1130.
5. Baruch Fischhoff, “Debiasing,” in Judgment Under Uncertainty: Heuristics and Biases, ed. D. Kahneman, P. Slovic, and A. Tversky (New York: Cambridge University Press, 1982).
6. A. Tversky, P. Slovic, and D. Kahneman (eds.), Judgment Under Uncertainty: Heuristics and Biases (New York: Cambridge University Press, 1982).
7. Amos Tversky and Daniel Kahneman, “Availability: A Heuristic for Judging Frequency and Probability,” Cognitive Psychology 5 (1973): 207–232.
8. Amos Tversky and Daniel Kahneman, “
Intuitive Predictions: Biases and Corrective Procedures,” Management Science, Spring 1981; Amos Tversky and Daniel Kahneman, “Causal Schemata in Judgments Under Uncertainty,” in Progress in Social Psychology, ed. M. Fishbein (Hillsdale, N.J.: Lawrence Erlbaum Associates, 1973); Don Lyon and Paul Slovic, “Dominance of Accuracy Information and Neglect of Base Rates in Probability Estimation,” Acta Psychologica 40, No. 4 (August 1976): 287–298.
9. Amos Tversky and Daniel Kahneman, “Belief in the Law of Small Numbers,” Psychological Bulletin 76 (1971): 105–110.
10. Value Line New Issue Survey.
11. T. Loughran and J. Ritter, “The New Issues Puzzle,” Journal of Finance 50, No. 1 (1995): 23–51.
12. J. R. Ritter, “The Long-Run Performance of Initial Public Offerings,” Journal of Finance 46, No. 1 (1991): 3–27.
13. David Dreman and Vladimira Ilieva, “The Performance of IPO’s during the Great Bubble 1996–2002,” working paper, The Dreman Foundation, 2011.
14. H. Nejat Seyhun, “Information Asymmetry and Price Performance of IPOs,” working paper, University of Michigan, 1992.
15. M. Levis, “The Long-Run Performance of Initial Public Offerings: The UK Experience 1980–88,” Financial Management 22 (1993): 28–41.
16. Bharat Jain and Omesh Kini, “The Post-Issue Operating Performance of IPO Firms,” Journal of Finance 49 (1994): 1699–1726.
17. Loughran and Ritter, “The New Issues Puzzle,” 46.
18. Tversky, Slovic, and Kahneman, Judgment Under Uncertainty.
19. David Dreman, “Let’s Hoard Crude Oil,” Forbes, June 8, 2009, p. 104.