How to Outsmart Your Investing Instincts

0:02Speaker 1:Bloomberg Audio Studios Podcasts Radio News Welcome to Merrin Talks Money, the podcast in which people who know the markets explain the markets. I am Merrin Somerset Webb, and this week I'm speaking with Alex Edmonds, Professor of Finance at London Business School and author of the new book, The Madness of Markets, Why Smart Investors Make Crazy Decisions. and how to exploit them.

0:34Speaker 2:And here it is.

0:35Speaker 1:I want to speak to Alex today because we've had him on before, and we had a fascinating conversation about his previous book, May Contain Lies, how story statistics and studies exploit our biases and what we can do about it. But in this conversation about this book, we talk about why even the smartest fund managers still invest irrationally, the link between football results and stock market performance, how luck and skill influence how we perceive investment performance, and much, much more. Alec, thank you so much for joining us today.

1:03Speaker 1:I really appreciate it.

1:04Speaker 2:Thanks, Melvin. It's great to be back. As I say, I love this book.

1:07Speaker 1:I thought it was absolutely great. But you know what? If I was a bookshop owner and I was looking at this and I was going, hmm, where should I put this in my bookshop? I would find myself hovering between whether to put it in finance and investing or in self-help. Because it does what self-help books do, right? It tells you, well, this is the way the world is supposed to be. And oh dear, it's not that way. Your life isn't working out as you thought. So here's how it should be. Here's how it really is. And here's what you should do about it. And that's basically how all self-help works.

1:41Speaker 2:So that's why I'd be hovering.

1:43Speaker 1:But in this case, when we look at the bit about how the world should be, and we're talking about investing, it's supposed to be efficient. It's supposed to be about fundamentals. And it's supposed to be about fundamentals all the time. The market is supposed to know everything. The market is supposed to be based on discounted cash flow, on dividends, on P ratios, on press-to-book ratios. But your starting point is that it demonstrably isn't. And the idea that anyone still believes any version of that is absurd.

2:14Speaker 2:That's correct. And that's what motivated writing this book. So I did my PhD at MIT in finance. I looked at what drives the stock prices. My professors were saying it's fundamentals, forecast future cash flows and discount rates with some hopelessly complicated model. But I had spent a couple of years at Morgan Stanley in London and also Morgan Stanley in New York, and I saw that even really sophisticated people, yes, they did use equations and quantitative factors, but they are human. They are affected by emotions. And then one of my earliest papers, I looked at, can the market be affected by something as crazy as a football result? So what do I look at football? Well, there's other things that drive national mood, such as a lockdown or a plane crash. But if you found the market fell after a plane crash, that could be just economics.

2:57Speaker 2:It could be that there's going to be less travel and more restrictions.

3:00Speaker 1:And there aren't quite enough as well to really, I mean, fortunately, there are not quite enough plane crashes. In countries with big liquid markets, for make this a reasonable way to look at it.

3:10Speaker 2:Exactly. So when you have a small sample size, it could be due to some confounding factors. But what Michael and I were able to look at was 1,150 football matches. And the idea is that football doesn't affect profits or dividends or non-farm payrolls. But we found that the market systematically fell the next day after a defeat. And this was interesting and surprising to us because most people will agree, yes, my emotions are affected by my sports results or my family situation. But when I get into the office, I'm going to put my game face on. I'm a professional.

3:40Speaker 2:I'm going to forget about this sentiment. But again, you're human and a human will be affected. Your judgment might be clouded by some of these extraneous factors. And then this led to the open the door to the wider measures of sentiment that can be affecting your emotions, your decisions. And that's what's in the book.

3:57Speaker 1:Yeah, there were two other little interesting things on that football story which I found fascinating. One was that there's a rise in death after a football loss, a rise in heart attacks. So, you know, the market is probably minor next to the fact that a football loss actually increases the number of heart attacks. And also that after a win, the market doesn't go up. So the market, in terms of sentiment, feels misery more than it feels joy.

4:21Speaker 2:Yes, sadly, these are quite depressing findings. So let's go through them in turn. So the effects of emotions. Yes, I feel sad if England gets knocked out or if my local team loses. But you might think, well, this is just going to lead to some just minor mishap. However, people have died. So in England, heart attacks went up when England were knocked out of the 1998 World Cup. If you cross the pond, you go to Canada. Suicides rise when the Montreal Canadiens get eliminated from the ice hockey.

4:50Speaker 2:And while in Canada, people kill themselves, in America, people kill each other. So sadly, murders go up in the local city after the NFL team is eliminated from the playoffs. And you might think, well, on the flip side, what happens when you win? Are you jubilant? Do markets rise? Sadly, no, it's only a negative effect. And this could be because of loss aversion. So a win hits positively much less than a loss hits negatively. And also it could be that supporters are overconfident about their team's chances of winning.

5:19Speaker 2:So for 60 years now, England have gone to every men's World Cup thinking this is the year. And if you think you're going to win, you do win. You're not too surprised. But if you lose, you're bitterly disappointed.

5:29Speaker 1:We'll get to overconfidence later. But there was another idea used about sentiment, and that was the weather, which I thought was quite interesting. I don't I'm sure you've read these studies as well, but they may still be coming out. I don't know, but 20 years ago or so, people were constantly telling us that the stock markets moved with the moon, moved with the lunar cycle, and that was to do with serotonin in the brain. And now you tell us that, in fact, markets move with weather.

5:53Speaker 2:Yes, and this was actually the inspiration for my football paper. And this was taught to me at MIT by somebody who believed in efficient markets, actually to argue why markets were efficient. Because he said, yes, there are studies which show that weather affects stock returns. But how do you know this is not a spurious correlation? You could correlate stock returns with cloud cover and rainfall and snowfall and wind and so many other factors. And if one of them just happens to be significant, you show this to everyone and you hide away the results that don't work.

6:23Speaker 2:He was saying, and I think there is some truth to it, is there a really convincing reason why the weather will affect your trading behaviour? Yes, you might feel upset on the commute to work if you're being rained on, but you are working from an air-conditioned, heated office. That should be something you're able to put aside. This is why I decided to look at football results, is that you have a much stronger effect than you do of the weather. Nobody has died or had a heart attack because of weather conditions. And also it's correlated across the country.

6:52Speaker 2:So it could be sunny in New York, but cloudy in Chicago. And maybe it's Chicago fund managers who are making the trade, so New York weather should be irrelevant. This is why I looked at international football rather than the Premier League, because if England lose, the whole of England is depressed, and this may drive the market down.

7:09Speaker 1:There's another bit, a bit later in the book, that I looked at, and it was about watching traders when they're watching the Fed to see what an interest rate decision is going to be, for example, and what happens to their body. And it shows that their hormones, you look at cortisol, a couple of other things. So their bodies change. And the phrase you used was that they're like a predator waiting for a kill.

7:30Speaker 2:Yeah. And this was really surprising to me because you might think is sentiment just about fluffy feelings. But no, it affects the hormones that seep through your body. So this was a study done by John Coates, who was a trader turned neurobiologist. So he would explore traders in action a bit like David Attenborough, but on the trading floor rather than in Antarctica. And he would measure their hormones and they would just be coursing through the body.

7:54Speaker 2:And when you have so much of, say, cortisol in the system, that has to be something which affects you. So just like people may have committed some crimes based on some serotonin in the body or lack of serotonin, it may well be that you take some pretty devastating decisions based on the hormones in the system. Let's talk.

8:13Speaker 1:About some of the things you've picked up in the book that explain, well, describe rather than explain how people behave. So one of those is, well, actually there's loads. There's herding, which is the obvious one.

8:26Speaker 2:Yes, absolutely. It's talk about herding. And behind any crazy behaviour, there is a grain of truth behind it, which is why such crazy behaviour can perpetuate and why even smart people can exhibit this behaviour. So what is the idea of herding? It's that, well, I want to be open-minded. I want to listen to other opinions and maybe there's some smart people and I can learn from what they do. But sometimes we are learning from other people who are also being based on psychology and emotions rather than fundamentals.

8:53Speaker 2:So it may be that I see that other people are investing in cryptocurrency and I see that they've made a lot of money. But there's a couple of issues with this. Is what I'm seeing a selected sample? So my five friends who've made crypto thousands, it could be there were 95 other people who also invested in crypto and they're keeping quiet about it. They're very quiet about that.

9:13Speaker 1:So that's a combination of hurting and extrapolation because that's one thing that investors do constantly. In fact, we see it all around us at the moment, don't we? Extrapolation of something that's happened over the last few years. into the future without thinking about whether it's really sustainable or possible.

9:27Speaker 2:Absolutely. And this is why I think these biases are so difficult to shake because they are not specific to financial markets. We see this all the time. So over-extrapolation from little bits of data we see everywhere. Go to any football stadium on the weekend, if the manager's lost three games in a row, then they'll call for his head. even if he's had four great seasons. Let's say there's a microaggression at work or you get excluded from a meeting.

9:50Speaker 2:You think, do I quit this company? A single ghosted date. You think dating is pointless. And so we exhibit this behavior. Nassim Taleb wrote about this in terms of fool by randomness. we over extrapolate from small trends.

10:02Speaker 1:And we're really foolish about it as well. I mean, if you think back, one of the things you talk about in the book is COVID and the great boom then and how a bubble actually in stocks such as say Zoom and Peloton. And anyone could have looked at those at the time and said, you know, this will end. This homeworking thing will end. This being locked up in our houses, of course it's going to end. And when it ends, people will go back to hanging around face to face like we are now. And when it ends, people might prefer to ride their bicycle, you know, actually outside.

10:29Speaker 1:These things will change. But instead of which, the valuation suggested people were extrapolating Zoom usage to the moon and extrapolating riding on bicycles inside until no one will ever have an outside bicycle again. And this was nonsensical, but it happened anyway.

10:44Speaker 2:Yes. And this is because we focus on salient information. So what we can see right now, and this causes us to be very short-termist. So in the pandemic, people are locked down and we're having all our interactions on Zoom. And so Zoom went up by 700%. Now it is clear to anybody right now, and it should have been clear at the time, even without hindsight, that that rivals like Google Meet and Microsoft Teams would catch up, that the world would open up again and people might realize they do enjoy human interaction and we want to have in-person conferences. But if right then you are seeing all these interactions on Zoom, then you will over extrapolate. And again, this is a general phenomenon which keeps repeating. Okay.

11:38Speaker 1:And connected to herding and extrapolation is this other old classic, which is Overconfidence. And one of the most heartbreaking bits of the book, I find, I mean, there's lots of bits in here about how you can win and lose money, but I always find it particularly distressing when you hear about people who've made a lot of money in a particularly excellent way, sportsmen in particular. You know, you've got a short career, finance isn't your thing, investing isn't your thing, running around is your thing. You make a pile of money.

12:04Speaker 1:And then as a result of being far too confident in your abilities to either choose a wealth manager or to invest yourself, it's all gone.

12:11Speaker 2:Yeah. And this is a very sad example. So it's the example of the V11, which was made famous in a recent BBC documentary. So you had some great footballers like Brian Dean or Rod Wallace or Danny Murphy, who made decent money in football, not the sums that you're making right now. And they decided to invest for the future. And they invested in some schemes, which end up being extremely damaging. Some of them were just poor investments. And others, they were said to have some tax advantages and yet they didn't manifest and therefore HMRC has come after them.

12:44Speaker 2:And you might think, well, do we want to shed a tear for wealthy footballers? Were they being arrogant by moving into property portfolios? But no, they were doing what people suggest they should be doing is, well, you want to save for the future. And going into property wasn't because they had an idea that I'm going to be some amazing property magnate, but that might be what they know. If you're a footballer, you can get onto the property ladder earlier than everybody else. And they were given advice that this is for the future. The asset management firm Kingsbridge, the name even, gives the idea of being something reliable that you can invest in, you can trust in. And I think the overconfidence here was putting too much weight on two things. Number one was the advisors themselves not knowing their perhaps misaligned incentives. And number two, the herding that we refer to. So when one footballer heard about this, they started to tell their friends, again, not to scam them.

13:37Speaker 2:They were genuinely trying to help their teammates. And in a sport in which trust in your teammates is everything... actually to take some financial advice from somebody who seems to be ahead of the curve, seems to be something reasonable, which is why I wanted to highlight the danger of herd behavior behind any bad decision is a grain of sensibility, but make sure that you're trusting not only the person you're hearing from, but who they heard it from themselves.

14:04Speaker 2:And if it's a misaligned advisor, then that is problematic.

14:07Speaker 1:And there is, as I say, read the book, but there's a lengthy list of celebrities who've got things horribly wrong. I was distressed to hear that Kim Basinger, too, had ended up bankrupt.

14:15Speaker 2:Yes. What was her overconfidence? So she made some money through real estate gains and thought, well, let's double down and go down even further into this. And yet she realized, well, she didn't actually have skill in investing. And this is actually a more general phenomenon. is that we overestimate the effect of skill and we underestimate the effect of luck. So if you did well really in one year with one great investment, we think, well, let's now go all in because I have an act. I'm not just a great actress or a great footballer. I'm also good at picking stocks. But it may well be that you just were in the right place in the right time. You happen to invest in something high growth when growth was in vogue. And it is just a behavioral tendency to when things go well, we say it's down to us.

15:00Speaker 2:When things go badly, we will blame other circumstances. And again, apologies for another football analogy. After a team wins, the manager will say it's my team selection. After they lose, they'll blame the referee. And so this is why data doesn't shake us out of our overconfidence. Because you might think, well, yes, people are overconfident. I accept that. But won't they learn from their past trading behavior that they actually have no expertise?

15:24Speaker 2:And the reason is no, because we look at the data very selectively. Number one, we may not look at the benchmark. We may think we made 15% last year. That's great. Not realizing that buy and hold would have given us 20%. And when things go well, we might just champion this and say, well, this is evidence of skill. And when things go badly, we might think, OK, it was the right decision at the time, but we just got unlucky.

15:46Speaker 1:I think that's connected, isn't it, to all those other surveys you see about the majority of people believing that they are a better than average driver. And also one of my favorites from years ago when people, when house prices were falling back in the 90s. And everyone was asked to survey about whether they thought house prices would fall. And they said, well, everywhere else, yes, but not in my special neighbourhood. Not in my special neighbourhood. Very hard to extrapolate correctly about yourself, isn't it?

16:10Speaker 2:And again, this is extremely human. So if you survey people on anything, are you above average in terms of your driving ability, your sense of humour, your ability to get along with others? 90% of people will say they are above average, even though obviously statistically 40% of them will be deluded. Now, this doesn't matter for something like driving, because as long as I'm not a terrible driver, I can still get home safely. Even if I'm in the bottom one percentile, I will still be able to drive home.

16:39Speaker 2:But for investing, for choosing stocks, you do genuinely need to be above average. And notice the average here is not the average person on the street, but the average trader, which involves a lot of professional fund managers. So unless you genuinely think that you are above average, then maybe you should be holding an index fund. And the concern here is that often some of these people who are trading may think, well, I am above average because I'm successful in all the walks of life. But actually being successful in trading is a pretty unique attribute. So just because you happen to be a finance professor doesn't mean you'll be a successful trader. I can. given some inputs, construct an accurate valuation model, but I can't get those inputs.

17:20Speaker 2:I don't have the day-to-day contact with CEOs of companies. I don't have a large team of analysts. And so I myself, one of the sobering things that I've done after doing this research for the past 20 years is investing far fewer in single stocks.

17:33Speaker 1:Have you gone fund or handed your money over to a wealth manager?

17:37Speaker 2:Yeah, so funds, nearly always funds. I will be more in active funds than the average professor will advise you because I do believe in active management and market inefficiencies. But I believe those inefficiencies aren't so large that somebody like me can take advantage of them. But they are large that professional fund managers might be able to do so.

17:55Speaker 1:And we should say, by the way, that lots of things that we've been talking about, like football and weather and that kind of thing, the gains that you might get from that are so marginal that you're unlikely to cover your costs. It's more about the... the idea than the practicalities. There isn't anybody out there winning a football game fund.

18:09Speaker 2:Not to my knowledge. It might be coming.

18:11Speaker 1:Yes.

18:12Speaker 2:But indeed, the point of the failure, as you say, Meryn, wasn't to show that I can trade on football. But if the market overreacts to football, then what else might it overreact to? And then that might say, yes, let's go shorten a potential tech bubble or AI bubble or tulip bubble. Okay.

18:26Speaker 1:So let's look at this. We started off by saying there's a couple of things I want to talk about. I want to go on to talk about how you can get an edge in market's in a minute. But first, I want to talk about the fact that in the end, it is true that markets are based on fundamentals just over a much longer term than most people expect. So this is one of the things that you talk about at the beginning of the book, that in fact, value investing is the best long-term strategy, because in the end, value does out and fundamentals do out, but it just can take a very long time.

18:55Speaker 2:That's correct. It can take a long time. And as John Maynard Keynes said, in the long run, we are all dead. But I think rather than this being a frustration for us, it takes so long. This is actually a great opportunity.

19:07Speaker 1:Why?

19:08Speaker 2:Because it might mean that other people cannot exploit missed valuation. So what do I mean by this? So let's say we are at the start of 2009. We think, well, equity valuations are really low here. There's the financial crisis. But then you might think, well, if it was really undervalued, wouldn't everybody else have bought into this? And the answer is actually no, because if you're a professional fund manager, you might want to not want to go all in because maybe we haven't yet hit rock bottom. If the market goes down even more, then the end investors will see you underperforming your benchmarks and might withdraw their money.

19:42Speaker 2:So even if you're correct and the world rebounds, maybe you're just not around to enjoy this because your fund has been liquidated. So if you're an asset manager with flighty capital, you might not be able to take advantage of these mispricings. So then if you are just an amateur investor like me, what I did was I put significantly large chunk of my portfolio into equities at the start of 2009. And not just saying this with hindsight, because I actually emailed all my students at the time saying this and saying this is one of the applications of behavioral finance, which I was teaching in class. I had a 40-year horizon back then. And even if I have not got the bottom right, I do think the long-term direction is correct. Much more publicly, Clare College, Cambridge, they launched the 2048 fund. They said, we're investing for the next 40 years for research and teaching. They borrowed 15 million pounds. And 10 years later, that 15 million had doubled to 30 millions in the equity market, whereas the loan had only gone up to 20 million.

20:40Speaker 1:And that was early 2009, right? Fair College?

20:42Speaker 2:Correct. End of 2008, early 2009.

20:44Speaker 1:I mean, that was phenomenally brave. And as you say, the kind of thing you can only do with a genuinely long-term portfolio, which some of those British colleges really have.

20:53Speaker 2:And if you contrast that to some others, which over-extrapolated and moved too quickly, the Boots Pension Fund, I think they went out of equities because they just saw this being negative. They just got cold feet and then they sold out right at the bottom and not participating in the future fund. increase. Gordon Brown sold out of gold right at the bottom. And again, this is something which has cost taxpayers billions of pounds.

21:26Speaker 1:Okay, let's talk about some of the places where it might be possible to have an edge. Because one of the things you talk about quite a lot in the book is the intangibles that don't necessarily make it into a valuation model, but nonetheless offer value. And one of those things, I know you've written a lot about ESG and we've talked a lot about ESG in the past, but one of those things is it's simply governance, isn't it? Is a company well-governed to somehow find its way into your valuation model?

21:59Speaker 2:Yes. And this is one of, I think, where the strongest evidence is out of the ESG trilogy. I don't think those three things should belong together to begin with. I think governance is fundamentally different. But it should be quite natural for people to think governance does matter. We do care about the executives of a company. But sometimes this can be really difficult to measure. So you might look at some simplistic measures such as demographic diversity on the boardroom or independence. But those things don't really capture how well governed a company is. So what you might want to look at is diversity of expertise rather than just demographics or some measures of CEO character. And some of them in the book are hopefully quite entertaining, but there is a big point behind them. So one of them you just wrote about recently was where do you hold an AGM? So every year a company has to hold an annual general meeting. And a lot of this is routine. You present the accounts and you have some votes.

22:54Speaker 2:But the wild card is the Q & A at the end. And you can get some pretty harsh questions. Now, if you are a transparent CEO, you don't mind harsh questions because you then get the opportunity to set the record straight. But if you're somebody who's shifty, you want to avoid them. And how do you avoid them? You hold the meeting in as remote location as possible. And we can be quite creative about this. So there was a car company based in Detroit in Michigan, which held its meeting in McAllen, Texas. Most people would have never heard of McAllen. You might have heard of Houston. You could fly to Houston and then drive 300 miles to get there. Really painful for the CEO. So the only reason he or she would do that is if they wanted to make shareholders make the trip as well to make sure that they don't actually scrutinize him or her.

23:42Speaker 2:And you don't even need to stay within the US. There was a CEO of a US company which held a meeting in Lahore, Pakistan at the time of terrorist threats. So be very careful if you want to ask me a question. That was feisty. And so I think this is great because while this might seem entertaining, there's a big point behind it, which is we want the equivalent. of a poker tell, which is something that the CEO gives, says, or does, which gives away what they truly think about their company. And yes, CEOs say upbeat statements, but if you're choosing to be shifty, then that is something which is a sign of poor governance and may well be a sell signal.

24:18Speaker 1:Yeah, and one of the other interesting things you picked up there was that companies that may have more trouble than they're immediately admitting to in an analyst call will only take questions from the people who they know are the most bullish. That's quite a tell.

24:30Speaker 2:Yeah, so that was another really, really clever paper. So what they looked at was who is speaking in the analyst conference calls, and they could see whether they had given a strong buy or strong sell recommendation. And again, notice that it might be to your advantage to call on the strong sell analyst, because if you have a rebuttal, You want to be able to set the record straight. But if you were just cherry-picking the people who are asking you questions, then that suggests you don't want to take bad questions because you don't have good answers. And this was something which took place not just in the US.

24:59Speaker 2:It was replicated around the world. Sell if indeed the CEO is cherry-picking the most positive analysts.

25:05Speaker 1:The other things that you talked about in terms of governance, and I was really interested in the Costco case study where you talked about very, very high minimum wage there. And some people will look at Costco, not minimum wage, but average wage, should I say, Hourly wage. And some people look at that and go, well, every penny that goes to the employees doesn't go to the shareholders and this balance is wrong. But in fact, it's been a huge boon to Costco. Very, very low stock turnover, et cetera.

25:28Speaker 2:That's correct. And this was one of my own studies, which I wrote about 20 years ago, way before ESG was popular. And I never saw this as an ESG paper, but just a paper on human capital. So what is the idea? Again, when I was at MIT, people were looking at bricks and mortar and tangibles and sales and revenues. But I knew that the most important asset within a company was human capital. So I looked at, are companies that are great places to work, are they ones that are going to outperform? And what I found over a 28-year period was that companies which were in the 100 best companies to work for in America delivered shareholder returns that beat their peers by 2.3% to 3.8% per year.

26:08Speaker 2:that's 89 to 184% compounded. And I can control for recent performance and get around causality correlation issues. But why is that surprising? Because you might think, shouldn't everybody know that an employee-friendly company is good? As soon as a company gets added to this list, should it not be stuff enjoying a big price increase? And the answer's no for a couple of reasons. So number one, it may well be people have what you described earlier, Maren, this pie-splitting mentality that if my employees are being treated too well, then I'm overpaying them or underworking them. Indeed, when I was at Morgan Stanley, one day the vice president caught me laughing and he said, Alex, do not laugh because my boss, the managing director, will think I'm not a good VP for not working you hard enough. And even though that was a bit tongue-in-cheek, there was a little bit of truth behind this, was a great boss was one who squeezed as much as possible out of you.

27:00Speaker 2:And the second reason why people might not take this into account is even if they accept that employee satisfaction and corporate culture is important, what do I do with this? So if sales were 5% higher than I thought, I can increase every sale in my spreadsheet by 5%. But if I know that employees are happy and motivated, how do I change cell C23? And again, just like your earlier question, this is something which is not just in finance. We see this pervasively across all decisions. Which job do I take? I know deep down I care about more than just the salary. I care about do I like the people and the commute and the purpose of the organization and the camaraderie of the colleagues, but I will default to salary because it's something which is quantitative. Yeah. Okay.

27:44Speaker 1:Interesting. Um, So here's the big question then. All the things that you write about in the book, all the things that we've just discussed, all the things that are ridiculous, the thing that leads to bubble, the failure to focus on value, all the intangibles that we've discussed, you write about them brilliantly. But again, as you say, these are studies you've written before, other people have written before. This is not, you've put it together gorgeously, but it's not necessarily new information. Fund managers know all this, but they continue to make the same mistakes.

28:14Speaker 2:Yeah, so there is a puzzle here. So why is it not that after you see these papers published in the top journals that you don't just act on this and then the alpha disappears? And I think there's a couple of reasons. And number one is actually it could be rational for fund managers to ignore all of this great investment advice. Why? Because fund managers might not be trying to maximise return. And that might seem crazy, and maybe I'm going to get a lot of tomatoes thrown against me for this, but why? You are concerned about your clients, and you are in an industry where there's flighty capital. Again, if I was to short right now in the AI bubble, thinking it's a bubble, what if I'm wrong? What if it continues to inflate? If my peers are still in AI, and then I'm underperforming, then my investors are going to liquidate me. And this is what happened to Julian Robertson, who did the smart decision.

29:02Speaker 2:A tiger. at Tiger to exit from tech. And he was correct, but he was just early. And if you're early and right, you are plain wrong.

29:10Speaker 1:And he liquidated about 10 minutes before it all crashed around him, right?

29:13Speaker 2:Exactly. So almost on cue, almost immediately after his fun collapsed in March 2000, then the tech bubble collapsed, but he was just not around to enjoy the victory. I think the second issue here is a bit more behavioural. It's that sometimes exploiting these mistakes just goes against what human psychology tells us. So let's think about momentum, which is another very pervasive trading strategy. The idea that if we look in the short term, short term winners... keep winning, short term losers continue to sink. So what this tells you is that I should sell my losers and I should ride my winners. But in fact, we see the opposite behavior. It's really difficult to take a loss. If I bought a stock at 100, it's gone down to 80.

29:55Speaker 2:I tell myself it should bounce back. And again, behind any bad behavior, there's a grain of sensibility. Don't I tell myself investing is about being patient, looking to the long run, trying to ignore the short-term fluctuation? But in fact, if the future path is down, then it'd be much better for me to sell. It's just so hard for me to take a loss.

30:15Speaker 1:And the last part of the book is the self-help bit. It's the bit that hopefully will help some fund managers through this. And you give, I think it's 18 different things that one should think about and do. Can we just pick out maybe the two or three most important for an ordinary retail investor? What are the couple of things that they should pick out behaviorally to make sure they really definitely do?

30:35Speaker 2:Absolutely. Actually, I'll preface this by saying your introductory remarks were fantastic about why the book, it's not clear which section to put it into, is self-help or investing. And this is actually one of the motivations for the book, because before, who was it who invested? Professional fund managers, wealthy people. Who is it who invests now? Everybody. Because we've democratized investing. We've given the power to invest in everybody's pocket or smartphone. So this is something that everybody may be affected by overconfidence and herding. So what are the tips that we can put into practice? One of them is to know your edge. So if you're going to do something other than holding index funds, you need to have a good reason for why you're deviating. Do you genuinely have more knowledge about the future of AI than other people? Maybe I'm a doctor. I think this company is making beta blockers and I can understand them.

31:22Speaker 2:And I know that high blood pressure is going to be a phenomenon in the future. But do I know what the marketing spend is or what the pricing will be or what regulatory headwinds and tailwinds will be? If I don't have that edge, maybe I should be holding index funds. But maybe you do have a different edge, which is I have just more patience and endurance. I am not suffering from flighty capital. And that might allow me to make this contrarian value play that you've talked about a lot in your prior episodes. So that's one, which is know your edge. Second is know your objective.

31:52Speaker 2:We talk about this being a great fund or a great stock. But whether it's great for you depends on your investment objectives. And so for me, I actually have a very short horizon objective right now, despite my age. Why? Because I bought a house four years ago with a five-year mortgage. And when I refinance it next year, it's going to have a much higher interest rate than what I bought. This is going to hurt.

32:13Speaker 1:This is going to hurt. Thank God you put all that money in in 2009. You're going to be fine.

32:17Speaker 2:I'm not going to worry about you. Yes. And so that's why for me, I actually reduced my tech exposure quite a lot six to nine months ago, because even though maybe I might miss the top, I wanted to lock in those gains. And number three is to look at your whole portfolio. So not to narrow frame, we typically will say, oh, This is going to be on my ISA pick, and this is what's in my pension, and this is for my discretionary fund account. But our whole portfolio should be seen as one, including our human capital and including our house. Okay, those are great tips.

32:48Speaker 1:Now, listen, one of the other things that you mention a bit in the book, and I'm sure we can go into more detail another time, we'll do a whole other podcast on this, is why does it matter? in that a lot of people will say, well, the market is the market.

33:00Speaker 2:It's different.

33:01Speaker 1:The fundamental economy continues regardless of what happens in the market. Because that's not really true. As we've been taught over and over and over again, the market can affect the economy and the other way around. So that, I mean, for example, one of the things you point out is that when stock prices are very high for particular companies, they might overinvest. It's too easy for them to raise money for them both to borrow and to issue equity.

33:21Speaker 1:So perhaps they will overinvest and that will lead to overcapacity to supply problems and And crashes not just in the financial economy, but also in the real economy. I know you know where I'm going with this.

33:32Speaker 2:Yes, absolutely. Is there a sector right now which is very highly valued and might be spending a lot?

33:39Speaker 1:Perhaps it's showing us an example of market madness that with the knowledge from the book, we can avoid.

33:46Speaker 2:I don't think this is really important. So we often think, is the market just a zero-sum game? If some people are winning and other people are losing, do we really care? They're choosing to play the market voluntarily, so just allow them to do their stuff. But no, because it affects the stock price, and the stock price is a useful signal. So when prices are high, number one, it's really easy to raise equity. And number two, even if you are not raising capital because you're sitting on a lot of cash, that's just a signal that the market loves you. You should be investing more and doing more of what you're doing.

34:15Speaker 2:And again, we've seen this time and again. So in the 2010s, there was the shale oil boom, where I think about $ 300 billion was spent on exploration because the prices were high. In the tech bubble, a lot of companies went public because they were dot-coms and invested a lot of money in something which was not actually fundamentally that strong. So we use prices as a signal. It matters whether the price is correct. And then this means that any force that corrects overvaluation, rather than chastising them, we should welcome them.

34:44Speaker 1:That's an AI bubble. There's a bubble in hyperscalers. There's a bubble in CapEx. And retail investors should really be careful now. Now is the time to pull back, not put in.

34:52Speaker 2:Yeah, so I am cautious, but more quietly cautious than I might have been in other bubbles. So when you go back to Cisco, there you could have looked at the price earnings ratio. And even without the benefit of hindsight, you could say, well, that's 190 compared to Microsoft itself, I think three times Microsoft and four times Intel. So that's just a massive valuation. Right now, the price earnings ratios, depending on what AI stocks or index you look at, they don't, on the face of it, look to be that high, about 25 to 30. On the face of it. Now, on the face of it. So why might they actually be not so high? Because what is the denominator? The denominator is earnings. And those earnings may be unsustainable. So they could be huge capital expenditure from the hyperscalers and maybe meta. They're under pressure themselves not to spend so much.

35:38Speaker 2:In some cases, some of those earnings might be high because they are on unrealized gain from their own AI investments. So Microsoft owns stakes in OpenAI and Anthropic. And so we think, well, those earnings are temporarily inflated, then the true price earnings ratio is much higher than one might think. But because it's not so clear cut as in 2000 when there was a 190 valuation, it would be hard for me to say it's a definitive bubble. I myself have chosen to reduce my weighting in tech more generally, partly because I do think it's slightly overvalued, but also partly because of my refinancing needs and my objectives in a year from now.

36:19Speaker 1:And if you were looking at the market and thinking, well, there is a sector that is too cheap because everyone is so carried away with herd behavior and stories and is missing out on one sector. one area? Is there anything that you can look at and say, well, I think that's it?

36:35Speaker 2:For me, I don't think it would be a sector in terms of an industry, but a type of firm, which is an intangible intensive firm in terms of something with strong corporate cultures or strong other types of intangibles.

36:46Speaker 1:Excellent. There is one you mentioned in the book actually called the Sparkline Intangible ETF, wasn't it, which basically picks up on a lot of the intangible themes that we've been talking about.

36:53Speaker 2:Correct. So it goes back to value investing. You might think I'm a foolhardy person for mentioning value investing because isn't value dead? And what he claims is no, value is not dead if you actually correctly define the value of a company of not just its balance sheet, but also those intangibles. And then you do want to invest in value companies which have high total value, including intangible value compared to its stock price. Okay, brilliant.

37:17Speaker 1:Alex, thank you very much. I think we're pretty clear here that the madness of markets is just going to go on and on, isn't it?

37:22Speaker 2:Always a pleasure to listen to your podcast. Even more of a pleasure to be on it. Thanks so much, Mary. Thanks for joining us.

37:34Speaker 1:Thanks for listening to this week's Merrin Talks Money. If you like our show, rate, review and subscribe wherever you listen to your podcasts and keep sending questions or comments to merrinmoney at bloomberg.net. You can also follow me and John on Twitter or X. I'm at Merrin S.W. and John is John underscore Stepak. This episode was hosted by me, Merrin Somerset Webb. It's produced by Sam Asadi and Moses Andam. Sound design by Blake Maples. And special thanks, of course, to Alex Edmonds.