Biased Investor? You're Overlooking Value in Today's Markets

Today, we're going to take some historical perspective from David Dreman’s excellent book Contrarian Investment Strategies. On "fighting the last war," Dreman writes:
 

After their ignominious defeat in the Franco-Prussian War of 1870, the French General Staff attributed the loss to lack of the dash and daring that had characterized French armies under Napoleon I. The marshals and generals overreacted by stressing elan above all else, even though there had been revolutionary changes in weaponry since Napoleon’s time. For 44 years afterwards, French military maneuvers concentrated on fixed bayonet attacks in closely packed ranks, the tactic that had won the Emperor victory after victory. But 1914 was not 1812. When World War I started, the cream of the French army was slaughtered by the rapid precision fire of the German machine guns and the enormous destructive power of their artillery. The overreaction to the Prussian defeat resulted in 250,000 French dead in the first six weeks of the war alone, about the total number of American soldiers killed in action in World War II.

While Dreman was making a point about the human tendency to overreact to relatively unimportant details and drawing the wrong conclusions -- whether in military planning or investing -- this is also a fine example of what Kahneman and Tversky called “heuristic-driven bias” in their groundbreaking studies on the psychology of investing. More specifically, the French generals were guilty of the “representativeness bias.”

The French army under Napoleon was dashing. The French army under Napoleon was the dominant military force in the world.  Therefore, a dashing army is a dominant army, right?  

Of course this argument made no sense, and the German army made quick work of its flashier French adversary. It turned out that bravado and Gallic flair were no match for the cold, hard reality of machine guns. 

Not only did the French argument make no sense, it was also wildly inconsistent with the historical record.  In the American Civil War, General Robert E. Lee’s Army of Northern Virginia would have crushed the Army of the Potamac within a week if all that was needed was audacity and better-looking uniforms among the officer corp. 

Like the French generals described by Dreman, investors also tend to draw the wrong conclusions from history and to pick and choose only the historical examples that support their existing belief. (This is called the "confirmation bias," a different heuristic-driven bias that often accompanies the representativeness bias.) They take mental shortcuts, use imperfect rules of thumb, and make analogies that don’t stand up to the test of reality.   

For example, stocks “always” revert to single-digit price/earnings ratios at major bear market bottoms, right? Well, that’s what happened in 1982. And since the last secular bull market started with single-digit price-earnings ratios, so must the next one. 

A more astute analyst might point out that quite a lot has changed since 1982 and that this particular year might not be the best representation of today. Yes, like 1982, the economy today is wrecked and unemployment is high. But unlike 1982, inflation is virtually nonexistent and returns on competing investments (like Treasury bonds) are pitifully low. In an environment of near-zero inflation, price earnings ratios should be higher, all else equal

Investors who avoided buying stocks in 2009 because “price/earnings ratios weren’t low enough to signal capitulation” missed out on a near doubling of their money because they fell victim to the representativeness bias. 

Today, we see these bias at work in investor behavior. I'll start with gold. The representativeness and confirmation biases have completely overwhelmed investors in the "barbarous relic." Investors see that the Fed has doubled the monetary base -- and thus assume that inflation and dollar depreciation is imminent as a result, often making comments that this is what "always" happens.  Always? Really? 

Gold bugs love to mention Weimar Germany. But is this really representative of our situation today? Again, falling victim to the confirmation bias, gold bugs fail to consider the case of Japan. Japan's monetary tinkering -- politely called "quantitative easing" -- is every bit as aggressive as that of the Federal Reserve today. Oddly enough, Japan has seen deflation, not inflation, and a rising yen to boot. This doesn't confirm the gold bug case, however, so it's conveniently ignored.

Stock investors too have been overwhelmed with representativeness bias in recent years. Looking back at the past 10 years of miserly returns, investors have thrown up their hands in disgust, believing that things will never get better. But are the past 10 years representative of the following 10 years? It's doubtful. The stock market started last decade at record-high valuations after years of bubble gains. This decade started with stocks trading at low valuations not seen in decades and with companies across the board putting a greater emphasis on traditional sources of value -- like dividends.

As investors, we have to be cold, hard, and rational. It's a struggle to suppress our emotions when money is at stake. We're humans, not Star Trek Vulcans, after all.

Looking at the market dispassionately, there's value to be had. As I wrote in a prior article, some of the world's biggest and best dividend payers are very attractively priced and yield more than long-term bonds. Companies like Johnson & Johnson (JNJ), Procter & Gamble (PG), and Philip Morris International (PM) will survive any renewed period of volatility should it occur. All are currently priced attractively to offer high long-term returns. For a "one-stop shop," investors might also consider the WisdomTree Large Cap Dividend Fund (DLN). It's an easy and conservative way to enjoy a respectable income while we wait for the macro picture to improve.

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