Tuesday, February 28, 2012

Extraordinary Popular Delusions and the Madness of Crowds

Last November's WSJ's had a Jason Zweig article in which he reminded us of Charles Mackay's '41 book on market bubbles, whose title serves as this post's title. He pointed out how the author himself was fooled, just shortly after his book was published, in believing the "absurdly unrealistic projections of future growth" for railway stocks. Others, too, who have cautioned against bubbles often fall victim.

Investing is often equivalent to the "prisoner's dilemma," from game theory. Just recall for a moment how housing took off. Didn't you see at least one property whose value appeared completely absurd to you? But, the reality was that the price continued to rise! And so, were you the fool for not buying at the "absurdly high" price, but still below what it ultimately sold for (before tumbling)? Academic research has many articles on this topic, but as I recall, knowing you're in a bubble can be very difficult (impossible, perhaps?), and there is even debate as to whether you can tell when a bubble occurred!

No one wants to miss out on a rising market; to watch your friends accumulate great wealth (on their investments in growth stocks, real estate, or even tulips) can be quite depressing. Thus the dilemma.

What one has to be wary of are those who make fantastic claims about the future. Unfortunately "outlandish claims" only appear outlandish after the fact. We often experience what seems to be outlandish, only later to find out that it wasn't; likewise, what seems to make sense often does not. Surely many would have thought it outlandish to think that the esteemed veteran of Wall Street, Bernie Madoff, would have been a crook, or that OJ Simpson a murderer. And who would have thought that the Jets would have won the Superbowl in 1969, or for that matter, the Giants this year (after their less than stellar regular season).

More fuel, perhaps, for a challenge to placing too much stock in any one's predictions.


  1. Stephen Campisi, CFA and Value Biased InvestorFebruary 29, 2012 at 1:06 AM

    Great points regarding market overvaluation as a result of biases such as overconfidence, which results in "bubbles." Equally dangerous, and much more persistent is the overvaluation baked into the market as a result of simplistic assumptions and pricing models.

    Take the well known "Gordon Growth Model" or its more common name, the "Dividend Discount Model." This is drummed into the head of every beginning finance student and all CFA level one candidates. The simplistic assumption is that there is a long run growth of dividends that lasts into perpetuity. This rate is typically high, reflecting the same overconfidence that leads to market bubbles. Why? Because these models are very sensitive to estimation errors with regard to growth rates.

    Take a simple example of a stock with a return on equity of 20%, a required return of 13% and an assumed long term (i.e. perpetual) growth rate of 12 percent. This stock would sell at 40x earnings. Now, assume that the initial growth rate will decline over time until it matches the long term GDP growth rate of 5 percent. Reprice the expected dividends and the stock is now valued at 17.5x earnings (more in line with the long term PE of the stock market.)

    We see from this simple example that the 2.3x overvaluation for this stock was not due to "irrational exhuberance" but rather to the human behavioral bias of overconfidence, reflected in the mistaken belief that things will continue forever as we see them now, and that we are right in our estimations.

    We can hear Ben Graham whispering in our ear that we need a "margin of safety" reflected in buying a stock at a discount to its fair value. That's probably closer to its "intrinsic value" than current prices would indicate. Wonder why value stocks outperform growth stocks? They're not as prone to "overpaying risk." Read Arnott's research into the fact that stock analysts DO find companies with above average growth prospects, but they tend to pay 2x the correct multiple for this growth. Sound familiar?

  2. Excellent commentary; thanks! There's a PMAR talk in here!


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