The Ego, The Market, and The Mania

Our favorite holding period is forever.
Warren Buffett

In the early 1990s, Money magazine would periodically poll Americans to see how savvy they were about investing. Respondents sometimes were asked to choose among several numbers to find out the one closest to the recent level of the benchmark Dow Jones Industrial Average. Over time, the editors of the magazine began to recognize that, not knowing where the Dow was, could just as easily be a sign of investing intelligence as investing ignorance. They learned that the best investors often ignored the majority of what passes as important financial news.

Ignoring financial news is very difficult to do, especially now as we are getting bombarded with CNN updates on our cell phones. But as investors in the capital markets, it is a good skill to master; it is not reckless. As Warren Buffett explained, in his company’s 1993 annual report: “After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two. We don’t need a daily quote on our 100% position in See’s (Candy) or H.H. Brown (Company’s wholly owned by Buffett’s Berkshire Hathaway) to validate our well-being. Why, then, should we need a quote on our 7% interest in Coke?”[i]

This can be illustrated in the real estate market as well. Take your house for example. Can you imagine if you received daily quotes on the price of your home? (Essentially, you would have a realtor come to your house every day to put in a bid.) That would certainly become tiresome after a time and would most likely increase your stress levels.

And how exactly would the Realtors be establishing their prices anyway?

Consider the result of the 1987 study by the University of Arizona’s Gregory B. Northcraft and Margaret A. Neale, who is now at Stanford University. Working with real estate agents in Tucson, the professors took one randomly selected group of brokers to home in town and asked them to appraise its value. In addition to a guided tour, the agents received a 10 page packet of information about the house, including its $65,900 list price. Their average appraisal came in at $67,811.

Northcraft and Neale brought a second group of real estate pros to the house, giving them the same tour in the same packet of information, with one exception: the listing price was $83,900. This time, the average appraisal came in at $75,190 – a full $7,000 higher than the first group. Same house, same information. The only change was the anchor-the listing price, but that was enough to change the “starting point” for those professionals and therefore dramatically influence the way the house was valued. [ii]

Anchoring on a number, such as the “starting point” illustrated above can influence almost any financial decision you make, even when you have expertise about the issue at hand.

Speaking of anchors… On October 19 the Dow Jones Industrial Average marked the 19th anniversary of the stock market crash of 1987. By establishing another record – closing above 12,000 the first time. Now, the 12,000 mark is just an arbitrary figure of no special significance, however, it is interesting to see how other experts in the investment field have anchored around it:

• “Stocks stink and will continue to do so until appraised appropriately… the market needs the yield close to 3.5% before it approaches fair value, and that means Dow 5000… Nowhere near today’s level of 8500… Stocks historically returned more than almost all other alternative investments, but only when priced right and when the race begins.” (2002 – Bill Gross – manager Pacific funds)[iii]
• “A lot of companies–some 30% of the Standard & Poor’s 500–have benefited greatly from low interest rates and that buffer is coming to a fast and possibly brutal end.” (2004 – Charles de Vaulx – manager of the First Eagle funds)[iv]
• “I think the fair value on the S&P is about 700… I think the huge losses will come in 2005 in 2006, when the presidential cycle gets to the housecleaning phase.” (2004 – Jeremy Grantham – manager of Grantham, Mayo, Van Otterloo)[v]
• “2006 is the second year of the presidential cycle, which is typically been a week here for stocks. Recommendations for the first nine months of 2006: Cash and more cash!” (2006 – Jeremy Grantham)[vi]

Perhaps their warnings will appear more helpful in the future, but the behavior of the equity markets of the past two years offers a compelling illustration of how difficult it is to determine the fair value for stock prices.

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[i] Belsky, Gary & Gilovich, Thomas, 1999. Why Smart People Make Big Money Mistakes.

[ii]Belsky, Gary & Gilovich, Thomas, 1999. Why Smart People Make Big Money Mistakes.

[iii] Gross, William H. 2002. Investment outlook. PIMCO.com, September 2002.

[iv] de Vaulx, Charles. 2004. The funk on the street. BusinessWeek. May 2004.

[v] Morrison, Kurt. 2004. Why I think the S&P 500 is fairly valued at 625. Stock strategist, December 1, 2004

[vi] otter, Jack. 2004. What’s next for the market? Smart Money, January 2004