There is intelligence in crowds, and at other times, people act like lemmings. Another way to put it is markets are efficient, but they are not always rational.
On the one hand, you have a multitude of financial corporations funding armies of analysts, along with hedge fund managers and portfolio managers, all working 8-14 hours a day to study the companies making up the stock market. All are trying to find and exploit those stocks that have prices undervalued even by tiny amounts. The combined decisions of these experts determine current stock market prices. The efficient market hypothesis (EMH), developed by Eugene Fama, radically proposed in 1969 that stock prices fully reflect all known information.
On the other hand, people are not rational.
Behaviorist Richard Thaler found that people often make decisions using mental shortcuts that are not rational, and that are “recurring and predictable.” Recurring? Sure. Predictable? I am not so sure. For example,they sell a stock because they need money for Fluffy’s pet liver transplant or because they overspent at Christmas. They buy a stock because their buddy at work gave them a ‘hot tip.’
Sometimes the irrational behavior expands to larger groups. The dot-com mania of the late 1990s and the Dutch tulip-mania of the 1630s are periods during which the general investing public failed to make rational decisions about intrinsic value. EMH proponents struggle with the concept of manias, and they explain away individual irrationality by saying that since a rational person is on the ‘other side of the trade,’ they are always there to capitalize on the “mistake” made by the irrational person, and thereby restore the proper price.
So, how do we reconcile these two conflicting ideas?
A large focus of behavioral finance ought to be hindsight bias, which per Investopedia is:
“…situations where a person believes (after the fact) that the onset of some past event was predictable and completely obvious, whereas in fact, the event could not have been reasonably predicted.”
“Many events seem obvious in hindsight. Psychologists attribute hindsight bias to our innate need to find order in the world by creating explanations that allow us to believe that events are predictable. While this sense of curiosity is useful in many cases (take science, for example), finding erroneous links between the cause and effect of an event may result in incorrect oversimplifications.”
“For example, many people now claim that signs of the technology bubble of the late 1990s and early 2000s (or any bubble from history, such as the Tulip bubble from the 1630s or the SouthSea bubble of 1711) were very obvious. This is a clear example of hindsight bias: If the formation of a bubble had been obvious at the time, it probably wouldn’t have escalated and eventually burst.”
Having lived through the tech bubble of 2000, I perceived a dissonance between investors. You had some people saying “this time it is different” because their belief was that the Internet would transform society (in fact it has). They also believed that it meant valuation measures in financial markets had been forever changed (in fact they had not).
You had other people who disagreed, saying, “these valuations are not sustainable.” They could not find any rational explanation for month after month of increasing valuations…until the bursting of the bubble finally vindicated their concerns.
So? What can we do about it?
There are some long term valuation measures that could be incorporated into an investment plan – not for the purpose of timing these disasters – but for the purpose of making adjustments in market risk when these inevitable extreme conditions do occur. One cannot say with a straight face that relative market valuations in 1982 were anything like they were in 1999. While it impossible to predict the actual timing of market ‘reversion to the mean’ it is possible to adjust for changes in long-term risk. After all, expected future returns are in part a function of current valuations.
First, let me say there is nothing wrong with using only a simple buy, hold, and rebalance strategy. The act of rebalancing maintains a constant amount of risk in all market conditions. This is more than adequate for most investors.
But, for those like myself who have a constant need to ‘tinker,’ yet who understand the limitations of behavioral errors (including my own error with tinkering!) could add to buy, hold, and rebalance, a systematic method to adjust for valuation extremes. The process is to look at long-term valuation measures, and make incremental adjustments when those measures go to extremes. It is certainly an area for debate what those extremes might be and I do not believe any single measure is so indicative as to be controlling of all overvaluation scenarios, but if we were to review several measures in combination, I would choose these three:
Then, (1) make only a modest adjustment in one’s asset allocation (+/- no more than 15% of the stock/bond ratio) and (2) make and follow strict rules for entering and exiting the adjusted allocation. Again, use of this method is not to try to ‘beat the market’ or to attempt to time future changes in market price. It has everything to do with actually looking at market conditions from a long-term risk perspective, and it has to do with making only modest allocation adjustments, not jumping in and out of the market when extreme conditions affecting long term market risk happen.
One final caveat: Markets can stay irrational longer than you can stay solvent. Therefore, carefully choose an allocation range that you can live with, regardless of actual returns, if you choose to make valuation-based allocation adjustments at all. Simplicity is the easiest way when it comes to investing. Consider simplicity first if you are considering this more-complicated road.