What makes us invest the way that we do? And how do we process the information that we need for making investment decisions?
A few months ago, I interviewed to Ken Fisher, founder, chairman, and CEO of Fisher Investments Company, and portfolio strategy columnist at Forbes. He is also the author of Markets Can Never Forget (But People Do) on my weekly show, Goldstein on Gelt.
You can watch a video of the interview on YouTube.
Below is a transcript of my interview with Ken Fisher:
Douglas Goldstein: Can you tell us a little bit about the link between the stock market price/earnings ratios and stock prices?
Ken Fisher: Much of what we commonly believe about things is because of the way our brains work rather than the things themselves, and people have difficulty with that. Our brains were set up to process information a long time ago, but they were not really set up to deal with the kinds of modern phenomena that we also encounter today, and we process that information through those old processors. Things like price/earnings ratios are ones were we routinely presume because our brain naturally assumes that high P/Es are riskier than low P/Es, and this becomes part of a common culture that is widely accepted. People agree on it, but the fact remains at almost any time I put any information in a framework that is a framework of height, people will always see a heights framework as risky because we are descended from people where heights were inherently risky if you fell. You likely got killed or maimed, and if you are maimed, it's almost as bad as getting killed so heights were risky.
For example, if you pick a high P/E and flip it into any key that would be earnings divided by price and think of that as an interest rate as compared to other interest rates, the heights framework goes away and the compared of cost of money becomes more important. You become more rational and analytical, and you get closer to a reality that make sense in an economic way, but if you just think in terms of P/E, people auto default that high P/E is risky and low P/E is safe. Meir Statman has done a lot of work on this that was published long ago. Any way you measure it, looking at one, three, or five years, doesn't tell you anything at all about risky returns.
Douglas Goldstein: If you're buying something and paying 30, 40, or 50 times earnings, it is very expensive. You're saying that that's just how we are programmed to think and it's not really the reality of how the market works?
Ken Fisher: High P/E stocks over one, three, and five-year periods don't have a markedly higher or lower return than low P/E stocks except in the periods where high P/E stocks do better and periods where high P/E stocks do worse. But if you take out just a very few, which you could think of as outliers and outliers are always things that have a status of additional ones to throw out, it's likely not to be very meaningful and doesn't look at the bulk of the returns. So you don't see any effect that actually leads you anywhere on a predictive sense that anybody would ever want to bet on, and yet that's what our brains want to do.
The same is true if you think of, for example, the total market. People generally believe that things like markets are less risky when the market's P/E is low. They are more risky when the market's P/E is high and you can just measure looking at one, three, and five-year returns, how many times the market depends at this P/E level, that P/E level, and the other P/E level. High P/E tells you nothing about whether it will in the next year go up or down or by how much, because for example you can give me a high P/E market that has done terribly and I can show you a complete example of how an exactly identical high P/E time period over the next 12 months did wonderfully. It's actually very 50/50, and the same as true with low P/E. Low P/Es sometimes do wonderfully, sometimes they do terribly, and if you look again at one, three and five years, it's very 50-50, but yet that's now what our brains want to believe. One of the key things of behavior is that we tend to see information that confirms our prior biases and we tend to be blind to the information that contradicts some of these.
My newest book which came out last year, called Markets Can Never Forget (But People Do), is just chock-full of examples of the things where our memories just don't work for us in showing us what it is that we've often seen many times before. But because it's inconsistent with our prior bias, we don't accept it until we don't see it, so we're blind to it. One of the points that's amazing about our brains and our memory is that our memories about some things are very good. We're very good at recognizing facial patterns, for example, and holding them for a very long time period and being able to recognize somebody that we haven't seen for 20 years as their face changes and ages. We're really good at doing that, but that's a really old thing that we've done for a really long time with people. A lot of us are in the framework that once we have ever dealt with our own, what we tend to do is believe that all of our friends believe it. We tend to think it's true, which reinforces our tendency to believe it. Yet in fact, the message that I'm saying is check it out for yourself to see if it's really true because most of what you believe isn't really true. People find this troublesome, and they also find it to work and yet the whole world of markets takes advantage.
Douglas Goldstein: One of the very common numbers that comes out and affects the markets all the time is consumer confidence. How does that affect stock returns?
Ken Fisher: Consumer confidence is something that is largely and overly simple since it moves with the market with a very slight time lag. If you know what the stock market has done in terms of the global stock market, you know pretty much where the consumer confidence numbers are going to come out. When the market goes up, rising and performing well, strong consumer confidence tends to rise. When the market tends to be falling, consumer confidence is often updated and revised a little bit after they're initially released, but the revised numbers largely have a slightly lag effect to the stock market. The stock market is telling you the same thing- that consumers will be able to see how they're feeling. The point is so simple that most people don't want to believe it. For example, in the media it regularly says that you should be more optimistic because consumer confidence is up and that's the sign that things will be better ahead. On the one hand, the stock market is in of itself the leading indicator, and it always has been both on the upside and on the downside but an improvement in consumer confidence is really a statement that the stock market has already been up. It's not because consumer confidence is up, so you should be bullish, or that because consumer confidence is down, you should be bearish.
We see lots of these things, but we're just unwilling to accept them because we don't want to accept them. The most egregious that I know of are all of the features that surround deficits and debt. We have heavy biases with the Western world and much of the rest of the world. Everything that has to do with debt is that debt is bad and more debt is worse, but there are lots of examples that contradict it. But people don't want to look at those examples of where somebody had debt and they got into trouble, and therefore this reinforces their view that this is bad. The willingness of people that contemplate that their bias might be wrong is very low, very small. There's this tremendous desire to say which behavior was called accumulating pride, which is, "What if I'm smart? So you want to see me doing it again?" and that tendency really doesn't want to challenge its own belief system because when you challenge your own belief system about basic things, it's scary and as if you're ego-driven.
Douglas Goldstein: If you were to give advice to regular investors, what would be the number one thing that people should be doing when they're beginning to work on their own finances?
Ken Fisher: I presume that if you've been right, you're probably lucky, and if you've been wrong that you should be focusing on learning something that changes some belief set that you have. Otherwise, maybe you're overconfident if you're not ready to do that, and if you're overconfident, maybe you shouldn't be making your own decisions. There's a tremendous tendency among humans of all types to be overconfident, to presume that they can make decisions that aren't the basis as they don't really know anything.
Finance basically says, to make a long story very short, that you need to know something other people don't know or when you make decisions you'll either be right because you're lucky or more often be wrong and be worse if you made no decisions at all. I decide I'm going to buy stock X because I really like the new product that they're coming out with, which is a really easy thing for somebody to see that you might do that, and it goes up so you think you were smart. If it goes down, you think, "I didn't really decide to buy that stock; the broker sold it to me." The fact is, what a financier would say is that if you didn't know something that other people didn't broadly know, you shouldn't be making the decision, and if you're going to be an investor, you should largely just be passive. The part that says I want to give up my overconfidence is a very hard thing for most people.
The fundamental basis of investing should include an extra dose of pre-plan humility that is actually very hard for many people to engage in. Most people fall to this notion that behaviorists call "accumulating pride" and "shining regret," which associates success with scale repeatability and associates failure with victimization or bad luck. Our ancestors accumulated pride and shining regret in almost everything they did, which motivated them to keep trying, and we are the descendants of people who are very heavy priers because if you think of doing something as audacious as taking a stick with a stone point on it and running up next to some large animal and thinking you're going to stab it and take it home and defeat it, that takes a fair amount of confidence and a fair amount of willingness to take a risk that you don't get trampled in the process and killed yourself. We are the descendants of people who are very successful at engaging in these activities, where they were on the one hand overconfident, but they were good at what they did, compared to others who are not their descendants because they didn't pass on their genes. The fact is that that overconfidence plays really well in a lot of environments.
So, in a distant time in a tribal format, one time I had to go into the north, to the east, to the south, to the west, and the guy that comes back at the end of the day with a couple of gazelles over his skin is a big hero around the camp fire that night. The guy that comes back with nothing for the day comes back with a lot of excuses as to why it wasn't his fault. The winds are blowing the wrong way, there were big noises in the area that scared all the gazelles off, the neighboring tribe were making a lot of noise, but nobody really appreciates all the excuses. They leave and go back out to hunt the next day. The guy with both gazelles has turned into a real hero around the campfire and people are talking about how maybe the chief is going to have the guy marry one of his daughters. The next day, the guy who was unlucky the prior day may actually just stumble on a gazelle that had mangled its leg and can't get away, and even if he's a terrible hunter, he brings back meat because he got lucky that day, and that's still good for the tribe. The one that came back with the two gazelles accumulates pride as around the campfire they associate his success with scale repeatability, and the one who comes back with nothing associates his failure with victimization or bad luck that allows them to continue trying the next day, which for the tribe is a good thing.
We as people have been hardwired for millennia on accumulating pride and shining regret, and in that environment where we came from it is actually a beneficial feature to our society. In the environment where we're engaged in security transactions and capital market, it actually builds this overconfidence that causes us to do things that we really aren't able to do and the market takes advantage of us, which is central to some of the basic tenets of behaviorism.