Global Value: Bubbles and Emotions

Are we bad investors? That's the claim made by Mebane Faber in chapter two of "Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market." It's a book about avoiding bubbles, as the title indicates, and finding another way to earn above-average returns.

The connection between bubbles and that other way is emotion (also called "sentiment"). The author wrote, "The point is, in bubbles and crashes, extremes in valuation are also accompanied by extremes in sentiment."


Now, about being bad investors. Faber reported that most of us think we're better than we really are, something that's true in most aspects of our lives, including driving (as a famous study has shown). I'll add to the author's information by noting research also shows that the higher our testosterone levels, the more likely we are to be overconfident. That, in turn, leads to too much trading and lower returns. Not surprisingly, then, women are generally considered better investors than men.

For empirical support, Faber turned to DALBAR Inc. and its annual report titled, "The Quantitative Analysis of Investor Behavior." It follows the flow of dollars into mutual funds and has shown the average investor is not earning as much as the market.

From a broader perspective, he said, "Don't be too downtrodden; stock picking is hard - really, really hard." Consider these numbers from a study by Longboard Asset Management (based on the top 3,000 stocks between 1983 and 2007):

  • 39% of stocks were not profitable.
  • 19% lost at least 75% of their value.
  • 64% of stocks could not match the performance of their relevant indexes.
  • 25% of them brought in all of the market's gains.



This study, called "The Capitalism Distribution," made it clear that the odds are stacked against investors. Randomly buying stocks means there is an almost 40% probability you will buy one that will not be profitable, and only a 25% probability you will get one that makes money.

Faber also argued that individual investors are competing with "the most talented investors in the world." Let me challenge that assertion, to some extent; even professional money managers have bad years and some more than others.

Carrying on, the author explained that it's not simply a case of people being poor at investing, but that we handicap ourselves. It's our emotions; we get mad at ourselves when we lose money and enjoy a high when we make money. Responding to these cues, we tend to sell at the bottoms and buy at the tops.

Tracking of such matters is done by the American Association of Individual Investors (AAII). Faber summarized their results by noting that one of the worst times to buy American stocks in recent history was in January 2000; that, as you will recall, was just before the dotcom bubble burst. And, what month, he asked, did investors allocate the greatest portion of their portfolios to stocks (as opposed to bonds and cash)? January 2000.

When, in recent memory, should investors have been most heavily committed to stocks? In March 2009, the same month in which investors had their lowest allocation in stocks since 1987. This GuruFocus chart shows the SPY S&P 500 ETF from January 2009 to February 14, 2020, and how it has relentlessly risen since March 2009.

That gets us back to Faber's idea from the beginning of this review: Extremes in valuations go hand in hand with extremes in sentiment or emotions. In chapter three, the author will point us to an objective measure that he says will help us remove emotions from our investing decisions.

Conclusion

In chapter two of "Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market," Faber has shown that most of us are not very good investors, mainly because of our emotions.

Proof of that comes from several sources, including information showing that our collective asset allocations in the recent past have been the exact opposite of what they should have been.

If we are to become better investors, we need to get that emotion out of our decisions, and the author promised that he has a tool or measure that will help us do that.

Disclaimer: This review is based on the book, "Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market" by Mebane (Meb) Faber, published in 2014 by The Idea Farm. Unless otherwise noted, all ideas and opinions in this review are those of the author.

Read more here:



Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.