Following wrong signs gets you lost

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This article was published 31/10/2009 (5821 days ago), so information in it may no longer be current.

EDMONTON — Santa Clara University professor of finance Meir Statman tells of a survey that asked Europeans if they were satisfied with the life they led.

The majority of people in Denmark said they were “very satisfied,” while the prevailing response over all the European Union was that people were “fairly satisfied.”

At a presentation on behavioural finance for the Harrow Partners investment firm and University of Alberta School of Business, Statman explained Danes “set their expectations very low, so when they won the European championship in soccer, there was a national celebration.”

So it is with investing. Rather than researching fundamentals and market conditions, people often invest according to a variety of benchmarks that may be inappropriate.

For instance, during the current earnings season in which companies report quarterly profits or losses, there has been a rash of firms “beating the street,” namely announcing better earnings per share than financial analysts forecast.

“Sometimes corporations will do that on purpose,” Statman said in an interview. “They will lead analysts to believe there will be a 13-cent gain (in earnings per share), and they come with 14, and the stock is going to bounce as if this was the greatest news.

“And they hate to have small negatives. If they are going to have a one-penny loss, they will manipulate it to have a one-penny gain. If they are going to have a loss, they may as well take the full bath. That usually happens when a regime changes, when a new CEO says, ‘This other guy was an idiot, I’m just cleaning the decks so we can begin fresh.’ “

That questions the value of earnings “guidance” issued by companies.

“For an individual investor, you don’t care,” Statman said. “If you think it’s a good time to buy, who’s the idiot who is selling to you? Goldman Sachs probably knows more than you do, they’re professionals, they know the companies, why do you try to compete buying and selling against them?”

Statman said investors are confused by the stock market rally since March, in the wake of the pratfall it took last fall.

“We are still afraid. Can I really trust this thing? Maybe it’s a trick to get me in before it falls again. People are losing trust in (financial) advisers. Anger and other emotions are doing terrible things to us.”

He suggests a three-step approach to wise investing. The first is to know yourself, namely your goals, emotions and cognitive errors. The second step is to assure yourself, by knowing the science of financial markets and human behaviour. And third is to protect yourself, by making your financial adviser your ally.

Knowing yourself includes realizing if you have low expectations, and whether you have relative or absolute goals.

Statman tells of John, whose wealth falls from $4 million to $3 million, and Jane, whose wealth increases from $1 million to $2 million, with the latter being happier because we value “gains and losses more than levels of wealth.”

The science of financial markets is that diversification reduces risk and smooths out returns over the long haul. Statman makes the case U.S. markets fell 37 per cent in 2008, while global markets dropped 44 per cent; then U.S. markets have recovered only 21 per cent this year, compared with 34 per cent in global markets.

“The substitution for diversification is market timing, and the usual method is using P/E (price-to-earnings) ratios. People say, “Buy when P/E ratios are low, sell when they’re high.’ “

Yet a study showed one dollar put in the market in 1871 would now be worth $67,000; if it had been invested using the Rule of 26 — getting out of the market when the P/E is greater than 26, getting in when it’s lower than 26 — it would have been worth $60,000.

“The stock market is random. It has patterns that are so weak.”

Statman warns of commercials from brokerage houses and financial institutions that “emphasize winners,” but don’t show the people who lose money. “It’s like the broken clock that shows the correct time twice a day.”

In truth, people tend to get in and out of stock markets at the wrong time. A study by UBS from 1999 to 2007 showed the percentage of people feeling it was a good time to get into the markets was lowest in November 2002. Yet from that date on, the Dow Jones Industrial Average rose 97.3 per cent by October 2007, and the S&P/TSX was up 166.9 per cent by June 2008.

Similarly, human behaviour is such that, given equal prices, more people will buy a five-ounce glass overflowing with seven ounces of ice cream, than a 10-ounce glass with eight ounces of ice cream, yet the latter is the better deal.

As for protecting yourself by getting a financial adviser on your side, he suggests examining “what a financial adviser knows, and what he or she promises.”

— Canwest News Service