Against the Gods: The Remarkable Story of Risk (57 page)

In a discussion of Shefrin and Statman's work, Merton Miller, a
Nobel Laureate at the University of Chicago and one of the more formidable defenders of rational theory, made the following observation
about investors who do not rely on professional advisers:

For these investors, stocks are usually more than just the abstract
"bundles of returns" of our economic models. Behind each holding
may be a story of family business, family quarrels, legacies received,
[and] divorce settlements ... almost totally irrelevant to our theories
of portfolio selection. That we abstract from all these stories in building our models is not because the stories are uninteresting but because
they may be too interesting and thereby distract us from the pervasive
market forces that should be our principal concern."

In Chapter 10, I mentioned a paper titled "Does the Stock Market
Overreact?" which Thaler and one of his graduate students, Werner
DeBondt, presented at the annual meeting of the American Finance
Association in December 1985. There this paper served as an example
of regression to the mean. It can also serve as an example of the failure
of the theory of rational behavior.

I was a discussant at the session at which Thaler and DeBondt presented their findings, and I began by saying, "At long last, the academic
world has caught up with what investors have known all along."12 Their
answer to the question posed by the title was an unqualified "Yes."

As an example of Prospect Theory, Thaler and DeBondt demonstrated that, when new information arrives, investors revise their beliefs,
not according to the objective methods set forth by Bayes, but by overweighting the new information and underweighting prior and longer term information. That is, they weight the probabilities of outcomes on
the "distribution of impressions" rather than on an objective calculation
based on historical probability distributions. As a consequence, stock
prices systematically overshoot so far in either direction that their reversal is predictable regardless of what happens to earnings or dividends or
any other objective factor.

The paper provoked criticism from members of the audience who
were shocked by this evidence of irrational pricing. The dispute continued over a number of years, focusing primarily on the manner in
which Thaler and DeBondt had gathered and tested their data. One
problem related to the calendar: an excessive proportion of the profits
from selling the winners and buying the losers appeared in the one
month of January; the rest of the year appeared to have been about
break-even. But different tests by different folks continued to produce
conflicting results.

In May 1993, a related paper entitled "Contrarian Investment,
Extrapolation, and Risk" appeared under the auspices of the prestigious National Bureau of Economic Research.13 The three academic
authors, Josef Lakonishok, Andre Shleifer, and Robert Vishny, provided an elaborate statistical analysis which confirmed that so-called
"value" stocks-stocks that sell at low prices relative to company earnings, dividends, or assets-tend to outperform more highly valued
stocks even after adjustments for volatility and other accepted measures
of risk.

The paper was memorable for more than the conclusion it reached,
which was not original by any means, nor for the thoroughness and
polish of the statistical presentation. Its importance lay in its confirmation of Thaler and DeBondt's behavioral explanation of these kinds of
results. In part because of fear of decision regret and in part because of
myopia, investors price the stocks of troubled companies too low in the
short run when regression to the mean would be likely to restore most
of them to good health over the long run. By the same token, companies about which recent information has indicated sharp improvement
are overpriced by investors who fail to recognize that matters cannot
get better and better indefinitely.

Lakonishok, Shleifer, and Vishny have certainly convinced themselves. In 1995, they launched their own firm to manage money in
accordance with their contrarian model.

Thaler never recovered from his early fascination with that "very interesting" disparity between prices for which people were willing to buy and sell the identical items. He coined the expression "endowment effect" to describe our tendency to set a higher selling price on what we own (are endowed with) than what we would pay for the identical item if we did not own it.*

In a paper written in 1990 with Daniel Kahneman and another colleague, Jack Knetsch, Thaler reported on a series of classroom experiments designed to test the prevalence of the endowment effect.t4 In one experiment, some of the students were given Cornell coffee mugs and were told they could take them home; they were also shown a range of prices and asked to set the lowest price at which they would consider selling their mug. Other students were asked the highest price they would be willing to pay to buy a mug. The average owner would not sell below $5.25, while the average buyer would not pay more than $2.25. A series of additional experiments provided consistent results.

The endowment effect is a powerful influence on investment decisions. Standard theory predicts that, since rational investors would all agree on investment values, they would all hold identical portfolios of risky assets like stocks. If that portfolio proved too risky for one of the investors, he could combine it with cash, while an investor seeking greater risk could use the portfolio as collateral for borrowings to buy more of the same.

The real world is not like that at all. True, the leading institutional investors do hold many stocks in common because the sheer volume of dollars they must invest limits them to stocks with the highest market values-stocks like General Electric and Exxon. But smaller investors have a much wider range of choice. It is rare indeed to find two of them holding identical portfolios, or even to find significant duplication in holdings. Once something is owned, its owner does not part with it lightly, regardless of what an objective valuation might reveal.

For example, the endowment effect arising from the nationality of the issuing company is a powerful influence on valuation. Even though international diversification of investment portfolios has increased in recent years, Americans still hold mostly shares of American companies and Japanese investors hold mostly shares of Japanese companies. Yet, at this writing, the American stock market is equal to only 35% and the Japanese to only 30% of the world market.

One explanation for this tendency is that it is more costly to obtain information on securities in a foreign market than it is to obtain information on securities in the home market. But that explanation seems insufficient to explain such a great difference in holdings. There must be more compelling reasons why investors are so reluctant to hold securities domiciled in markets that account for 65% to 70% of the investible universe.

A masterful study of the influence of the endowment effect on international investing was carried out in 1989 by Kenneth French, then at the University of Chicago and now at Yale, and James Poterba at MIT.15 The target of their inquiry was the absence of cross-border ownership between Japanese and American investors. At that time, Japanese investors owned just over 1% of the U.S. stock market, while American investors owned less than 1% of the Tokyo market. A good deal of activity was taking place across the borders; substantial buying and selling of American stocks went on in Japan and of Japanese stocks in the United States. But net purchases on either side were tiny.

The result was a striking distortion of valuations across the markets. French and Poterba's calculations indicated that the small holdings of Japanese stocks by U.S. investors could be justified only if the Americans expected annual real (inflation-adjusted) returns of 8.5% in the United States and 5.1% in Japan. The small holdings of American stocks by Japanese investors could be justified only if the Japanese expected real annual returns of 8.2% in Japan and 3.9% in the United States. Neither taxation nor institutional restrictions were sufficient to explain disparities that would set von Neumann spinning in his grave.*
Nor could theories of rational investor decision-making explain them. The endowment effect must be the answer.*

The evidence presented in this chapter gives only a hint of the diligence of the Theory Police in apprehending people in the act of violating the precepts of rational behavior. The literature on that activity
is large, growing, and diverse.

Now we come to the greatest anomaly of all. Even though millions of investors would readily plead guilty to acting in defiance of
rationality, the market-where it really counts-act as though rationality
prevailed.

What does it mean to say "where it really counts"? And, if that is
the case, what are the consequences for managing risk?

Keynes provides a precise definition of what it means to say "where
it really counts." In a famous passage in The General Theory of Employment,
Interest and Money, Keynes describes the stock market as, "... so to speak,
a game of Snap, of Old Maid, of Musical Chairs-a pastime in which he
is victor who says Snap neither too soon nor too late, who passes the Old
Maid to his neighbor before the game is over, who secures a chair for
himself when the music stops."16

Keynes's metaphor suggests a test to determine whether the market
acts as though rationality prevails, where it counts: the prevalence of
nonrational behavior should provide endless opportunities for rational
investors to say Snap, to pass on the Old Maid, or to seize a chair ahead
of investors on the run from the Theory Police. If those opportunities
do not present themselves, or are too brief to provide an advantage, we
might just as well assume that the market is rational even though we
recognize that many irrational forces are coursing through it. "Where
it counts" means that there are very few opportunities to profit by betting against irrational investors, even though there is so much evidence
of their presence in the market. Where it counts, the market's behavior conforms to the rational model.

If all investors went through the identical rational thinking process,
expected returns and adjustments for risk would look the same to
everyone in possession of the same information at the same moment. In
the unlikely event that a few investors succumbed to nonrational
behavior, they would end up buying high and selling low as betterinformed investors were driving prices back to a rational valuation.
Otherwise, prices would change only when new information became
available, and new information arrives in random fashion.

That is how a fully rational market would work. No one could outperform the market as a whole. All opportunities would be exploited.
At any level of risk, all investors would earn the same rate of return.

In the real world, investors seem to have great difficulty outperforming one another in any convincing or consistent fashion. Today's
hero is often tomorrow's blockhead. Over the long run, active investment managers-investors who purport to be stock-pickers and whose
portfolios differ in composition from the market as a whole-seem to
lag behind market indexes like the S&P 500 or even broader indexes
like the Wilshire 5000 or the Russell 3000. Over the past decade, for
example, 78% of all actively managed equity funds underperformed the
Vanguard Index 500 mutual fund, which tracks the unmanaged S&P
500 Composite; the data for earlier periods are not as clean, but the
S&P has been a consistent winner over long periods of time.