Chapter One
QUESTION ONE: WHAT DO YOU BELIEVE THAT IS ACTUALLY FALSE?
If You Knew It Was Wrong, You Wouldn't Believe It
It's safe to assume if you knew something was wrong, you wouldn't believe it was real and true in the first place. But in a world where so much of industry applied craft has morphed into long-held mythologies, much of what everyone believes is false. This isn't any different from long ago when humanity believed the world was flat. You needn't beat yourself up if you fall prey to false mythologies. Pretty much everyone has and does. Once you know and accept that, you can begin gaming everyone else.
If sorting false mythology from fact were trivial, there wouldn't be so many false truths. While this isn't trivial, it isn't impossible either. One inherent difficulty is this approach requires being skeptical about all your prior beliefs, something most humans dislike. In fact, most humans hate self-questioning and prefer spending time convincing themselves and others their beliefs are right. Effectively you can't trust any conclusion you thought you knew.
To think through false mythologies, we must first ask: Why do so many people believe things that are false? And why do false truths persist-getting passed down the decades as if they were fact? It comes back to the same point: People persist in believing things that are wrong because, individually, people rarely investigate their own beliefs, particularly when what they believe makes sense intuitively-even more so when those around them agree with them. As a society, we are often encouraged to challenge someone else's views, as in, "I know those @&%$#! (insert either Republicans or Democrats as you choose) are full of phony views!" But we aren't trained to challenge ourselves or to question the basic nature of the universe the way an Einstein, Edison, or Newton would. Our instinct is to accept wisdom passed to us by former generations, or smarter people, or both. These beliefs don't require investigation because we believe certain truths are beyond our ability to challenge. Often in life, that is right. I mean if "they" can't figure it out, how could I?
Medicine is a good example. We are correctly conditioned to go to the doctor, describe symptoms, hear prognosis, and accept a prescription. Generally that is good conditioning because medicine is an example of science and craft operating largely in parallel harmony-not perfectly because there are certainly plenty of myths among doctors-but generally because over time science modifies the craft and the craft improves. Because there are so many life examples where our conditioning serves us well, we are blind to the few areas, like capital markets, where it doesn't.
There are myriad beliefs you're likely to share with your fellow investors. These beliefs have been built into decades of literature and are among the first things people learn when they start investing and have been accepted by the biggest names around us. Who are you to question and challenge them?
Exactly the right person!
For example, take the notion high price-to-earnings (P/E) stock markets are riskier than low P/E stock markets. (For those few of you who are newcomers to investing and not familiar with P/E, it's the price per share divided by the earnings per share, and is perhaps the most basic and famous valuation metric for stocks. The same calculation can be aggregated for all stocks of a type or the whole market to create a notion, for example, of the entire stock market's P/E.)
Investors categorically believe when the stock market has a high P/E, it's riskier and has less upside than when it has a low P/E. Think about it casually, and it probably makes sense. A high P/E means a stock (or even the whole market) price is high-way high-compared to earnings. Get too far out on that scale, and it would seem a high P/E means a stock is vastly overpriced and likely to start falling. This belief is so widely held by so many people, seems so logical, and has been a basic tenet of investing for so long that if you start proposing to your friends it's false, you will meet with overwhelming rejection, ridicule, and perhaps suggestions you're morally deficient somehow.
Yet, I proved statistically more than 10 years ago the P/E, no matter its level, by itself tells you nothing about market risk or return. Statistics aside, if you delve heavily into theory (as we do later), you will also learn the P/E shouldn't tell you anything about risk or return anyway. But tell that to people, including the overwhelming bulk of people who have been trained and should know better, and they will think you're crazy-a real whack-job. The cool part comes after we accept the truth that P/Es tell you nothing about future return by themselves-when people are freaking out, fearfully fretting over the market P/E being too high, we can bet against the market falling. While that won't always work because something else can come along and knock the market down (we cover how to see that later), it will work much more often than not. In the same way, if the market's P/E is low and we can sense people are optimistic because of it, we can bet against them also. The key is understanding the truth instead of the mythology. This is basic to the scientific approach.
Many false mythologies-just like the P/E one-are accepted widely by the best and brightest minds and passed to the investing public through all forms of media. They don't inspire questioning from you, me, or anyone. We have faith in them, like Catholics do in the Trinity and Environmentalists in Global Warming, and they require no further proof. Holy! Sacred! No one questions these beliefs. No one offers dissenting analysis. And if you do, you're a heathen. Because there is no dissenting opinion, society feels no need to see proof of these alleged investing truisms with statistically valid data. And mythology continues.
How can it be, with over half of Americans having some sort of investment account as of 2005, almost no one demands hard evidence to support generally accepted investing wisdom? Why do investment decisions not get the scrutiny that car mechanics do? We should be at least as skeptical, if not more so, of the financial industry's pronouncements than we are of a Volvo dealer's. To change the success (or lack thereof) you've had so far with investing, be skeptical. Be a cynic. Be the one to point out the emperor wears no clothes. Look around and assess what you and your fellow investors are accepting as truth. But the most important person to be skeptical of is yourself.
Long ago as I read or listened to media, I'd note things I believed were false and run off to do independent checking to prove I was right. (People love to prove they're right.) I'd gather data and do statistical analysis to prove they were wrong and I was right; and I could prove I was right to my satisfaction pretty often. (It's amazing how often people can prove they're right to their own satisfaction-the plaintiff, judge, jury, and executioner all in one.) But later I realized I was doing the wrong thing. What I should have been doing is looking in the media for assertions I believed were true and then checking to see if they weren't really false. Why?
If I believe the assertion is true, then probably so do many others, if not the overwhelming bulk of investors. Maybe everyone. And if we're all wrong, there is real power there. If I can prove I'm wrong and most everyone else is also wrong, then I've got some useful information. I can bet against everyone knowingly. I've got one provable form of knowing something others don't.
Suppose I believe factor-X causes result-Y. If I believe it, probably most other folks do too. But if I'm wrong, everyone else is wrong. When X happens, people will move to bet on Y happening. Suppose I can learn X doesn't cause Y. That means something else is causing Y. That means after X happens, Y happens sometimes, but it's purely random to X's existence. Now when X happens, people will still move to bet on Y happening, but I can bet against Y happening and I'll be right much more often than I'm wrong. (If I can figure out what actually causes Y, I can take a big step further, but we don't cover that step until Chapter 2 and Question Two.)
With our P/E notion, we can see one such perfect example. Say the market's P/E goes up-a lot. Normal investors notice and conclude risk has risen and future return is lower and bet against the market doing well. Sometimes stocks won't do well, but more often than not stocks will be just peachy because the P/E by itself tells you nothing about market risk and direction. When I see a high P/E market and fear of it, I can bet against the market falling. Sometimes, like 2000, it won't work. But more often, like 1996, 1997, 1998, 1999, and 2003, I'll be right. I don't expect you to believe the P/E thing right now. Right now I expect you to believe the traditional mythology about P/Es and not even be very interested in challenging it. (We get to that later in detail.) For now I just want you to accept in your bones if you can learn an accepted mythology is actually false you can bet against it and win more often than you lose.
Using Question One
A good way to think about successful investing is it's two-thirds not making mistakes and one-third doing something right. Hippocrates is frequently credited with the phrase, "First, do no harm," and it's a good investment principle.
To first do no harm, you must think about what you believe and ask yourself whether it's correct and factually accurate. Go crazy. Question everything you think you know. Most people hate doing this, which gives you a real advantage over them. As stated in this chapter's title, this is the first question: What do you believe that is actually false? If you want, you can change "false" to "wrong."
Asking Question One only helps if you can be honest with yourself. Many people, particularly in investing, are constitutionally incapable of contemplating they're ever wrong. They will tell you they do well and likely hoodwink themselves into believing it-but they don't. And they never subject themselves to reliable independent analysis. You must accept that you and the pundits and professionals from whom you glean information can be and probably are wrong about many basic beliefs. Me too!
Have you ever presented such a question to yourself about capital markets? Asking yourself if what you believe is actually wrong requires introspection. As humans, we're hardwired to be overconfident. This is hardly a new development. Behavioralists will tell you our Stone Age ancestors had to be overconfident to hunt giant beasts each day armed merely with stone-tipped sticks. If they practiced introspection and came to the rational conclusion that tossing a flint-tipped branch at a buffalo was utter lunacy, they, their families, and their communities would have starved. In fact, overconfidence-the belief you can do something successfully for which rationality would argue otherwise-is basic to human success in most fields and necessary to our successful evolution as a species. However, it hurts tremendously when it comes to capital markets as we see in Chapter 3.
Just so, investors are loathe to question generally accepted knowledge. If we started doing so, we might soon realize the market exists solely to humiliate us as much as it can for as long as it can for as many dollars as it can. I refer to the market by its proper name, "The Great Humiliator" (TGH for short). I've come to accept my goal is to interact with TGH without getting humiliated too much. TGH is an equal opportunity humiliator. It doesn't care if you're rich or poor, black or white, tall or fat, male or female, crippled or an Olympian. It wants to humiliate everyone. It wants to humiliate me and you, too. To be frank, I think it wants to humiliate me more than it does you. You're fun to humiliate, but if you're fun, I'm more fun. I have my Forbes and Bloomberg Money audiences laughing at me and over $30 billion worth of clients fussing at me when I screw up. Think how much TGH would love to humiliate Warren Buffett. The bigger you are, the more TGH wants you. But in reality, TGH wants to get everyone and does a pretty good job at getting them all. Can't be sated!
How do you, personally, give TGH the most fun? By making the most bets you can based on the same information everyone else has. How do you spoil the fun for TGH? By restricting bets you make to things you think you actually know that others don't.
Practice using Question One the same way I should have-by scanning the media for things asserted you believe. Make a list of them. They can be about single stocks, whole markets, currencies, or anything. Try looking at a stock, regardless of whether you own it or not, and asking yourself, "What would make me buy or sell this particular stock? What information is providing the impetus for a change?" Make a list of anything influencing your decisions.
Make note of decisions you've made not supported by data or any other information. Underneath there somewhere is something you believe-might be right or might be wrong. Be particularly wary of making a decision simply because of something you know others agree with. Highlight, underline, and asterisk decisions prompted or based on common investor catechism. Ask, what evidence did you figure out for yourself supporting these beliefs? Is there any? For most investors, there isn't much.
Common Myths You Believe In Too
For example, you may hold a stock with a high P/E ratio. You believe a high P/E signals an overvalued stock so you decide to dump the stock and buy one with a lower P/E. It's a fairly rational decision you may have made countless times before, and one many people would agree is rational.
But are high P/Es bad for single stocks or the market? Have you personally checked the data? If you have asked the question, where did you find the answer? Did you look at the numbers, or did you rest easy because conventional wisdom or some big-name guru endorsed your belief?
Take another scenario. You hold a stock that does well in rising markets but badly in falling ones, a typical highly volatile stock. However, you know the U.S. federal government is running a growing budget deficit-not only a deficit, but a historically high deficit and one that "can't go on forever." You know federal budget deficits left unchecked are "bad for the economy," and in turn "bad for the stock market." All that debt caused by the deficit must be paid back by future generations, and the market will reflect that sooner or later, right? The burden of the deficit has long-term rippling implications, holding down growth and earnings. The deficit has grown to such a size you know a bear market looms eventually. In that environment, your highly volatile stock would do badly and so you sell.
But how do you know budget deficit peaks are followed by poor stock performance? Is it true? Most folks won't ask the question or check history. If they did, they would be sanguine about stocks rather than fearful. Historically, big budget deficits in America and around the world have been followed by materially above-average stock market returns. Don't fear deficits-it is big budget surpluses that have been soon followed by bad markets, like President's Clinton's surpluses in 1999 and 2000.
That doesn't make intuitive sense to you. Deficits must be bad and surpluses good, right? After all, the word deficit has the same Latin root as deficient-and that must be bad. Most folks won't challenge their own beliefs on these kinds of subjects. The notion that big deficits are bad is overwhelming. Few beliefs have as much broad acceptance from professionals, nonprofessionals, and folks from both ends of the political spectrum alike. A good way to get the proletariat on your side at a political rally is to vow to lower budget deficits. It's a crowd pleaser.
(Continues...)
Excerpted from The Only Three Questions That Countby Kenneth L. Fisher Copyright © 2007 by Kenneth L. Fisher. Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.
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