Anyone who makes even a passing effort to follow the market is familiar with sensational descriptors. Earnings can “explode higher” or “rocket up” but they can also “crash” or “plummet”. Whether it is sensational stories, tantalizing TV shows, or captivating quotes, we just can’t seem to get enough drama — and this makes us easy targets for dramatic presentations.
Our ingrained affinity for drama isn't a problem per se, but it becomes one when it is necessary to get the facts right. Otherwise, drama can systematically distort our world view. At least this is the case made by Hans Rosling in his recent book, Factfulness. While the book serves as a general guide for analysis and problem solving, it could hardly be more applicable than in the realm of investment analysis.
To begin with, Rosling is well placed to produce such a guidebook. As a physician, a professor of global health and a public speaker, he had plenty of opportunities to interact with people from all over the world and from all different backgrounds. He was listed [here] as one of the 100 leading global thinkers by Foreign Policy and was included in the Time 100 list of the world's 100 most influential people. He was probably best known for his incredibly popular TED talk [here].
One of the very interesting things that Rosling discovered over the years was that most people get the world wrong. They either don’t know the data or rely on the wrong data. As a result, they are "Not only devastatingly wrong, but systematically wrong ...” In other words, people’s understanding of many important issues is worse than if they "had no knowledge at all."
This is such a shocking result that Rosling was compelled to search for its cause. He found it in the form of drama. He explains, "We are interested in gossip and dramatic stories, which used to be the only source of news and useful information." In fact, we are so interested because we are wired with such instincts.
He illustrates this by way of analogy: "Our cravings for sugar and fat make obesity one of the largest health problems in the world today. We have to teach our children, and ourselves, to stay away from sweets and chips. In the same way, our quick-thinking brains and cravings for drama — our dramatic instincts — are causing misconceptions and an overdramatic worldview."
Rosling rightly asks, "So how could policy makers and politicians solve global problems if they were operating on the wrong facts?" How can anyone? Misconceptions range far and wide and yet people still systematically adhere to wrong facts. Obviously this poses an especially potent risk for investors.
Fortunately, Rosling, ever the teacher, provides a "set of simple thinking tools" that are designed to help people avoid biases in their analysis. In doing so, he highlights various "instincts" that effectively bypass our mental efforts at factfulness.
Several of these are especially relevant to investors: The straight line instinct is the tendency to assume that recent experience will be extrapolated into the future in a straight line; the size instinct is the tendency to disregard extreme numbers because they are meaningless except in relation to something more familiar; the destiny instinct is the tendency to operate on a knowledge base established in the past even when things have changed since; and the single perspective instinct is the tendency to accept simple answers even for very complicated issues.
For example, portrayals of the capacity for US economic growth are often dramatized by appealing to the destiny instinct. Many people have learned in college economics courses (or on their own) that free market economies tend to perform better because the market is more efficient at allocating capital than centralized control systems. Further, they are taught that the US is a paradigm of free markets.
These concepts were highlighted recently by the Financial Times [here]. Accordingly, free markets "boost economies and make everyone better off in the long run" as a function of the process of "the funneling of cash earned from the productive activity (work) of ordinary investors into the financing of new productive activity."
Despite a strong history of productive recycling, however, this activity ground to a halt in the last three years. As the FT also reports, "Over the past 50 odd years, consultant McKinsey estimates that US companies have returned about 60 per cent of the earnings to shareholders [leaving 40 per cent for reinvestment]. In 2015, 2016, and 2017, that rose to more than 100 per cent [leaving nothing for reinvestment]."
Further, it's not hard to understand why this activity has changed so much: "Cheap money has made it far cheaper and easier for companies to borrow and buy other companies, to borrow and buy back shares, and to borrow and pay dividends than to attempt to create value via the laborious path of increasing productivity and organic growth." In short, facts have changed about the economy, but many attitudes have not.
The destiny instinct creates misconceptions about equity returns as well. Because stocks have performed well in the past, investors believe that it must be "destiny" for stocks to always outperform. This tendency has also been reinforced by the "Siegel Constant", which is the notion that over the long term, stocks generally provide a real return of about 6.6%. This assessment of stocks is the bread and butter of many financial advisers and consultants but completely overlooks major changes in demographics and debt levels that can radically reduce returns in the future.
Views on stocks are also often influenced by the single perspective instinct. A single perspective is embodied in views such as "you've got to own stocks" and "there is no alternative" (TINA). Both of these beliefs, along with others like them, discourage active consideration of viable alternatives.
Yet another aspect of investing that is often subject to dramatic instincts is the notion of market efficiency. This is essentially the degree to which prices determined by the market are reasonably accurate representations of intrinsic value. It is an important issue because an enormous body of economic and financial research uses market efficiency as a foundational assumption.
Although a great deal of investment advice is predicated on the assumption of market efficiency, much of the substantiating data has changed. As Mohamed El-Erian reports in the FT [here], Price discovery has changed because money flows have changed: "According to Morningstar, passive US equity funds attracted some $220bn in flows last year, taking their total to almost $7tn, while active funds shed $207bn." Further, this change in ownership has "diluted specific company and sector signals, and smaller gradual price moves have been dwarfed by the generalising influence of index investors." In short, passive funds are setting the prices and they don't care about fundamentals.
While drama instincts can create misconceptions by overlooking the data, they can also kick in even when the facts are agreed upon. Rob Arnott explained [here] "Vernon Smith won the Nobel Prize for his groundbreaking work in experimental economics ... Smith showed that even though investors share the same information, they do not come to the table with common expectations. As a result, even when market participants are all aware of a formula-based value for an asset, they will overpay or underpay relative to a known fair valuation."
He then goes on to show how this happens: "More recent research shows how investor expectations around 'greater fools' and future price movements are strongly influenced by recent market returns, further encouraging the formation of bubbles. Greenwood and Shleifer (2013) studied six sources of survey data of investor expectations for future market returns. They showed that investors behave with strong extrapolative tendencies: following periods of strong market returns, investors become used to strong performance and extrapolate it into their expectations of future market returns. For example, a Gallup survey showed that investors increasing their expected market return from 12% in mid-1998 to 16% by early 2000."
Indeed, "extrapolative tendencies" fit well into Rosling's description of the straight line instinct. Here though, the tendencies apply to the interpretation of data rather than the body of data itself. Still, it is useful to be aware of this potential when analyzing the investment landscape. Consider, for example, Arnott's claim that "Not only are the market prices of most tech darlings far above reasonable valuation models, investors are overwhelmingly positive and projecting high future returns." How can this be when there is a fair amount of agreement about what the cash flows (data) are?
The answer is that a number of investors are interpreting the same underlying data in a much more optimistic way. Arnott highlights this optimism with some indicative sentiment readings: "The Wells Fargo/Gallup Investor and Retirement Optimism Index sits at its highest level in 17 years" and "The University of Michigan’s Index of Consumer Sentiment now shows an all-time record for favorable assessments of current economic conditions."
All of this boils down to a few key ideas that can help investors improve results. One is to cut down on your intake of drama in order to facilitate any serious analysis. One aspect of this to get the data right. There really is not a good excuse in this day and age of data accessibility to just get data wrong. Exert the effort to get it right. This lesson also applies to interpretations of data, however. Be sure to check your interpretations in the context of multiple perspectives to ensure they have not been influenced by dramatic instincts.
In addition, dramatic instincts arise in a wide array of financial and economic issues. Massive debts and deficits, for example, are especially vulnerable to the size instinct because the numbers are so big as to be almost meaningless to most people. In addition, economic growth and equity returns are habitually subject to straight line instincts which project the recent past performance indefinitely into the future. As a result, performance tends to overshoot both on the way up and on the way down.
A final idea is that there are many indications that markets are not functioning as well as they used to and the implications are serious. For one, there is likely to be lower growth in the future. This is based on the fact that cash flows are not being reinvested at the same rate and therefore the capital base is not growing as fast. For another, inefficient markets completely undermine the value proposition of index funds and passive ETFs by putting their investors at great risk of material losses. Of course these implications will be far worse for investors who fail to detect them in time.
At this point, it would be fair to ask why is there is so much drama in the realm of investment analysis? The short answer is because there is big money in drama. It's easy. It motivates people to pay attention. It motivates people to act. And it undermines people's ability to make sound decisions. What's not to like if you are a purveyor of services of marginal quality? For many providers it is simply easier and more lucrative to formulate investment advice that appeals to dramatic instincts. It should go without saying that less dramatic evaluations of the investment landscape have a much better chance of providing valuable insights.
In conclusion, according to Rosling, "we need to learn to control our drama intake." As he puts it, "Factfulness, like a healthy diet and regular exercise, can and should become part of your daily life." This is not to suggest, however, that investors should go "cold turkey" on drama. As Rosling also prescribes, "We still need these dramatic instincts to give meaning to our world and get us through the day."