Monday, 27 April 2009

Book Review: Mean Markets and Lizard Brains by Terry Burnham

This book is at once entertaining, thought-provoking, frustrating and self-contradicting in attempting to combine the research on irrational behaviour from behavioural finance (the Lizard Brains) and an assessment of current macro-economic and stock/bond/real estate market conditions (the Mean Markets) in the USA. Author Burnham, a former Harvard economics professor and an investor, sets out to show readers how to make sound investing decisions.

Irrational Thinking or Misleading Language?
Burnham argues the Lizard Brains parts by analogy and by stories, and therein arises both the pleasure and the frustration I had in reading this book. The stories are amusing but rigour and precision (though sources are duly cited) go by the wayside. Ultimately, that undermines confidence that his advice is correct. Our supposed irrational thinking may not actually be so at all.

For example, on pages 248-249, Burnham relates the famous "conjunction fallacy" (see Wikipedia's entry on conjunction fallacy for a brief explanation) using the Linda problem first tested by Tversky and Kahneman in 1983. The failure of most people to get the right answer is the conjunction fallacy and the cause is supposedly an inability to cope with probability and a mistaken use of the representativeness heuristic. Burnham goes on to cite research by a professor Gerd Gigerenzer who found that people got the correct answer if he simply re-phrased the question in terms of frequency instead of probability. We must think in terms of frequency or get it wrong. Instead of concluding that humans cannot cope with financial markets, maybe the simpler conclusion is that we should closely examine statements and thoughts, reformulating them to see if that changes our perspective. We need to beware of the wording of statements since others may deliberately or accidentally mislead. Therefore we don't need to assume that people cannot think straight. The Lizard Brain works just fine.

Lizard Brain Out of Sync with Modern Financial Markets or Perfectly In Sync?
A few pages on (p.254-55), Burnham says that our ancestrally-wired Lizard Brains are not built to cope with the stock market since the situation is so very different and as a result gives this advice: "For investing, the only rule is to predict what everyone else is doing, and move to profit from their behaviour." But did ancient food hunts not require anticipating actions of animals, or did ancient battle success not depend on out-manoeuvring enemies? Is it a wrong-thinking problem we have today, or just an information overload and filtering challenge (for instance, what will be the impact of the swine flu on markets, can anyone really tell?). Some explanations of stock market bubbles suggest that trying to predict what everyone else will do is a rational source of bubbles. If you are trying to maximize short-term profit at the expense of greater fools, it does not matter what the true value of an Internet bubble stock is.

Time Keeps Moving On
Another problem of the book is that it presents a picture and assessment as of a moment in time - mid 2008 - and things have changed mightily since then. The discussion of the US economy and what would likely happen to markets is well argued and quite insightful given events of the 9 months since the publication. But would Burnham's advice on the relative value of stocks, bonds and real estate still be the same?

Assessments and Recommendations to Chew Upon:
  • Bonds - won't give attractive returns since interest rates are likely to rise, including real interest rates, so we are exhorted to borrow at fixed rates, invest in short-term bonds and borrow less overall
  • Stocks - we've been lucky for a long time and it won't continue (pretty good assessment for last summer)
  • Real Estate - prices will keep falling as there is 60 years of excess to undo (is that still the case in his view?); get a fixed rate, not variable, mortgage
Burnham's Signs to Decide If the Time is Right to Buy Risky Investments:
  • equity dividends are higher than bond yields
  • for stocks, when broad population ownership of equities is low
  • for real estate, when cash flow (rent etc) alone makes a profit without counting price appreciation
  • when household savings rates are high, debt levels are low and home equity to debt is high
  • when press and analyst investment scorn is directed at either stocks or bonds or real estate
A Piece of Trading Advice from Burnham:
  • Preserve options to either increase or decrease risk (i.e. keep the flexibility to do what Warren Buffett did by investing a huge amount in Goldman Sachs, which now seems to be doing very well ... though I doubt he quickly exited the "loser" when GS went down considerably after his investment at c. $110)
The last point dovetails with the statement on page 270: "... there is a systematic difference between great players and good players [of poker] related precisely to the decision of when to be fully committed. The great players tend to go all in with hands where they have a good chance to win." Yes indeed, therein lies the difference between those who state the theory of how to win at investing and the actual winners like Warren Buffett. Of course, there are not many great players. It is not so much a matter of irrationality and ill-adapted brains as good judgement and nerve. Maybe buy and hold index investing makes sense after all, Lizard Brain or not.

The writing is informal and free-flowing and thus enjoyable. The diversity of examples makes one think and provides much entertainment. It's a good fast read. But it is not destined to be a classic. Three out of five stars.


Michael James said...

I agree that some examples of "mistakes" that people make are just examples of the difference between technical language and common use of language. In the conjugation fallacy, if Linda is indeed both a bank teller and a feminist, then with common use of language, statement 2 (both bank teller and feminist) would be considered a "better" answer than statement 1 (bank teller), even though both are true.

I've seen other experiments that do a better job of exposing this fallacy, but they have problems as well. In one case, people are asked to guess how many words in a well-known short story end with a "g". Later on, they are asked how many words in the same well-known story end in "ing". People tend to give a bigger number for the second question. However, this isn't likely to be failure of logic. People simply don't think of "ing" words when they answer the first question. This is more a failure of imagination than a failure of logic.

CanadianInvestor said...

Hi Michael. Re explanations for why people don't answer "correctly", another is that training and experience can make the difference. Tim Harford's Logic of Life points out that the endowment effect, by which people hang on to something they own when they receive an offer they should take, disappears when tested with people who have a lot of experience dealing with that situation (he cites research by Prof. John List with pin collectors). Two thoughts come out of this ... 1) the inferences and conclusions one draws from these psychological tests may be subject to alternative interpretations and, 2) maybe the endowment effect affects stock investors - the neophytes hang on when they shouldn't while people who've bought and sold lots don't "fall in love" with a stock.

Apostille said...

This is a very good review about this book written.

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