A Rational Plan

First published August 21, 2004

To invest in the stock market is to plunge into an emotionally charged arena fraught with erratic and random price fluctuation. We are dealing in probability and most people struggle with the uncertainty and behave badly. N. N. Taleb writes, “ We humans are not endowed with rational probabilistic thinking and optimal behavior under uncertainty.”

There are exceptions. Billionaire George Soros is one of the rare ones. Expressing his admiration for Soros as an investor, Taleb says, “He knows how to handle randomness by keeping a critical open mind and changing his opinions with minimal shame (which carries the side effect of making him sometimes treat people like soiled napkins).” Further, “He walks around calling himself fallible, but is so potent because he knows it, while others have loftier ideas about themselves.”

Manners aside, Soros’ main strength, it turns out, is that he knows he will often be wrong and is quick to pull the plug on a bad investment.

The majority of us are not so dispassionate. Citing the Nobel Prize-winning work of behaviorists Kahneman and Tversky, Taleb tells us that, rather than think rationally when dealing with uncertainty, we resolve the problem by employing heuristics and biases.

A heuristic is a method of working out a solution in response to a subconscious desire to protect our fragile psyches. It is necessarily blind to reasoning.

Here is an example. A friend who reads these essays recently said, “I believe you are right, Rod, and it has paralyzed me. I haven’t done any investing, but I haven’t sold out yet, either. Can’t afford to…gotta wait ‘till my stuff comes back.”

I can relate. Been there.

Why is it that we will be rational about our cash position in a situation like this (we won’t buy into an obviously risky market), but not about the money that is presently exposed to this risk?

I’m not sure about the heuristic my friend is employing here, but I’ve got a good idea that one of his biases is the insane fear that the moment he sells out of this overvalued, wildly speculative market it will go screaming  up without him. Another bias would be a severe distaste for the idea of taking a loss. Note that I say the idea, not the action itself. I know from personal experience that if he were to sell out today, tonight he would get the best sleep he’s had in months (or years).

Almost everyone suffers from the same problem. The Investment Company Institute (www.ici.org) reports that the average value of 401Ks owned by investors aged 60-65 peaked at year-end in 1998 at $134,000. Despite five more years of contributions, at the end of 2003 the average value had declined to $127,00. Massive denial going on here, to be sure.

Taleb is a trader who recognizes the same behavior weaknesses in himself. He maintains that he does not expect to be able to change his behavior; therefore, he works out mental ruses to enable him to trick himself into doing the right thing when he trades.

Pondering my friend’s all-too-familiar circumstance, I have devised a trick that might serve us all during the remainder of the bear market.

The Trick

Dollar cost averaging is buying stocks by investing fixed amounts at fixed intervals. It is held to be mathematically impossible to buy stocks more cheaply during the period of investment. A fixed dollar amount will buy more shares at the intervals when prices are low and fewer shares when the share prices are high. For long-term success, this strategy should be employed when stocks are in the lower end of their historical valuation range.

The current Price/Earnings ratio (valuation) on the S&P 500 is 20.4. We know from history that the 10-year forward return on stocks is close to nothing any time the S&P 500 average is valued at 20 times earnings or more. Moreover, long-term price charts show that from this level there is always a severe price decline, generally accompanied by awful economic and political news, making holding through such a period a dismal psychological prospect.

To have a shot at decent returns on a stock portfolio, we need to accumulate the stocks when the P/E is 10 or less.*

Therefore, my friend might call his broker with these instructions:

1)     I wish to maintain an appropriate allocation of stocks in my portfolio. However,

2)     I instruct you sell my stocks and put the stock allocation into a money market any time the P/E on the S&P 500 reaches 20, and,

3)     Begin dollar cost averaging that allocation back into stocks at the rate of 5% of the allocation per month whenever the S&P 500 P/E declines to 10 or lower.* In that manner, I will have reinvested over a two-year period during which stocks were at the lower end of their historical range.

“Oh, you say the P/E is now over twenty? Well, you have your instructions. Proceed accordingly.”

There, I’ve taken an irrational behavior and converted it into a sound strategy, elegant in its simplicity and mathematical grace.

Cheers,

Rod

*Today, August 26, 2011, I am revising the reinvestment point to when the S&P P/E is less than 5. Given that the ultimate low will be at the bottom of a Grand Supercycle bear market, I may even revise it lower a couple of years from now.

The author makes no representation as to the accuracy of the quoted material, but believes the sources to be reliable. No one should consider any part of this presentation as a recommendation to buy or sell any securities whatsoever.

 

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