Editor's Note: The following article is part of an ongoing series on the Psychology of Investing and was initially run as a Rule Breaker Portfolio report.
In part 4 of this series, I'll be looking at an experiment run by John Allen Paulos. Mr. Paulos, to those not already familiar with him, is an author and mathematics professor who loves to analyze our inability to make sense of numbers, and the psychology that lurks behind that. Mr. Paulos's first book was Innumeracy, and he followed it up with A Mathematician Reads the Newspaper. His latest book is Once Upon a Number: The Hidden Mathematical Logic of Stories. (But I'd start with Innumeracy, if you're interested.)
Past Psychology of Investing series entries have related to framing, anchoring, and typicality. Here, I'd like to examine an anecdote Mr. Paulos provides on page 117 of A Mathematician Reads the Newspaper. He writes:
"In a perverse mood, I informed one of my classes early in the semester of a new rule: Anyone who checked a box on the exam sheet would have an extra ten points added to his or her exam score, unless the number of students checking the box constituted more than half the class. If more than half the class checked the box, those checking it would have ten points deducted from their exam scores."
What do you think happened? Those aware of the fundamental risk-aversity that is part of human nature probably have a leg up on answering the question.
At first, very few people checked the box. "Hey, I think I'll get an A anyway -- why should I risk getting a B off of some lucky extra-credit challenge?" For most students, the risk of losing outpaced the reward of winning.
However, as Paulos writes, "The students were concerned about their rank in the class, [so that] even those who didn't wish to gamble had to take the actions of their fellow students into account in deciding whether to check the box."
You can probably imagine what happened then. Word of the success of their fellow students -- those who took the risk to check the box -- spread. "It worked for Sam!" someone mused, about an otherwise mediocre math student. Ah, but that second time around, most people still wouldn't check the box, figuring the success of the strategy would be short-lived, as word spread.
So it kept working.
Eventually though, as Paulos writes, "What happened is that progressively more students checked the box on the exam sheets as the semester wore on, until on one exam more than half the class checked the box and these students were penalized ten points. Very few students checked the box thereafter."
Now, as we are wont to do in the "Psychology of Investing" series here in Rule Breakerdom, let us apply the lessons learned from Paulos's inventive and devious experiment to the stock market.
Here, we may imagine that the "box checked" is analogous to "investing in the stock market"; checking the box is buying stock. At first, few are willing to do so, and those who do take the risk (which is essentially against mass human nature) are rewarded. Over time, more people buy in (check the box) and are all rewarded. But at a certain point, our analogy suggests, a large number of people will buy into the market, and everyone will "lose ten points."
This is a very interesting application of the principle "The pain of loss is three times the joy of gain," which I first read about in The Universe and the Teacup, but has been documented in numerous similar psychological studies. Basically, gaining 10% on your stocks is, for most people, about three times less influential than losing 10% on their stocks -- even though the same amount of money is involved. This is the reason behind few people initially checking Paulos's tempting little box. After a while, as the risk aversity breaks down and more people are willing to "gamble," more are rewarded. But the way he set up his experiment, once too many do this, everyone is burnt and we return to the initial state of risk-aversity, where few will check that box.
How fair and "true" is it, to apply this anecdote to the stock market? A great question. I'd love to hear what you think. Here's what I think.
First, the stock market does not have any fixed mechanism where once X% of people invest, it will then drop X% due to their over-enthusiasm. The stock market is ultimately based both on investor perceptions and corporate profits. The latter have shown an unerring ability to rise steadily over time.
Second, there is no specific limit (of which I am aware) that anyone has determined that shows what "X" equals, when we speak of X% of people investing. Are we "too over-enthusiastic" -- too bullish -- when 50% of America owns stocks, or 20%, or 95%, or what? I'm not sure there IS any answer to this question.
Some people seem to believe there is one, though. Today, we repeatedly come across mentions from them of "bubbles" and "tulips." These threadbare comparisons shed very little insight on the state of our markets, but all hint at the notion that "too many people are investing," investing is "not that easy," etc.
But as BDKliewer points out on our message boards, the Dutch tulip craze involved an underlying investment that had no ability to generate cash flow, quite unlike (in our case) the Internet. And the South Seas "bubble" popped because of fraud.
Of course, I think it is very helpful to remain cognizant of the potential that the stock market MAY work like Paulos's little checked box. Fools have open minds, and should ideally admit to many more possibilities than most people have even thought of.
All these things said, the more people I see using the mindless examples of "tulips" and "bubbles," the better I feel about owning the stocks that I do. That's because these critics are engaging in cliched herd thinking -- the mindless application of mostly irrelevant historical examples as precedents. Plus, their herd thinking is made more and more evident by the frequency with which other people go on to hastily cite these same historical examples, as if they're offering striking and original analysis.
So consider this: Perhaps it is the Prophets of Tulips and Bubbles who are checking boxes. Ever considered that? The more people who buy into their analysis -- who check their boxes -- the closer the analysis gets to collapsing and losing them all "ten points."
Another ten points.
Because Internet bears have been losing points at a steeper and more rapid rate than perhaps any group of bears in history!
The Psychology of Investing