Editor’s Note: For better or worse, economist Terry Burnham is increasingly notorious for predicting on this page that the Dow would hit 5,000 before it hit 20,000. He’s stood by his forecast as the Dow has rallied. It closed above 17,000 a year after he made his prediction. The Dow has now closed at over 18,000. So how does it feel to be wrong?
Burnham hasn’t been wrong yet, and he’s not changing his forecast. But, as he explains today, he’s started to suffer the pain that comes from not following the herd. “Pain is necessary, but not sufficient, for investing success,” he says.
A long-time critic of the Fed’s bond-buying program, Burnham is a former Goldman Sachs trader, biotech entrepreneur, money manager and economics professor at Harvard’s Business School and Kennedy School of Government. He’s the author of “Mean Genes” and “Mean Markets and Lizard Brains” and now teaches at Chapman College.
— Simone Pathe, Making Sen$e Editor
In July 2013, I made my “Dow 5,000” prediction that the Dow Jones Industrial Average would hit 5,000 before it hit 20,000. I have written about the macroeconomic and asset market events since my prediction. Today, I focus on the psychological aspects.
I Get No Respect
How do I feel 18 months after calling for Dow 5,000? Bad. In fact, very bad in a way that may be of more than personal interest.
In the spirit of the late Rodney Dangerfield, how bad do I feel? So bad that I have trouble sleeping. So bad that my family relationships are strained. So bad that my physical health has been impaired. Perhaps most annoyingly, so bad that I have a sore on my right arm that will not heal. I am not a doctor, but I am confident that my sore would have healed if I had not made my Dow 5,000 prediction.
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I feel a deep malaise, causing (in my mind at least), a low grade cough, sallow complexion, irritability and an impaired immune system.
I am surprised by my level of unhappiness. In a moment, I will discuss the rational reasons why I ought to be miserable. However, my psychological pain seems out of sync with the external reality of the situation. I will argue that there is a neuroeconomic and evolutionary explanation for my malaise. If these explanations have merit, then there are some (limited) lessons for every investor.
Rational Reasons for Self-Loathing
I am stupid, stupid, stupid. So says part of my brain (paraphrasing a line from “The Rainmaker”).
There are indeed rational reasons for me to feel stupid. First, and foremost, the stock market has rallied almost every month, week, day, and even hour since I predicted doom and gloom.
Beyond being wrong every moment for 18 months, I have faced continual external reminders of my shortcomings. Just a few weeks ago, a Bloomberg column headline blared “Market forecasts to ignore in 2015.” Mine was among the first.
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Furthermore, I am never without my Dow 5,000 prediction. At my children’s choir practice recently, a chorister grandparent greeted me with, “Are you still losing money?”
Similarly, at a school social event, a mom worked her way across the crowd, with considerable effort, to speak with me. She said, “I was talking about you recently with one of my most attractive girlfriends who is single.” I said, “That is flattering, but I am happily married.” She replied, “No, that is not the reason. Her husband was insane like you; he spent all their money building a survivalist compound; she just got divorced.”
Even when I go to a restaurant far from home, I imagine that the low-wage workers are fully invested in stocks and are whispering about me in the kitchen. “I saw that loser predict Dow 5,000 on CNBC.”
Isn’t It Rational to Feel Bad After Making a Fool of Yourself?
Why am I surprised that I wake up in the night, check the roaring Chinese stock market, and cannot go back to sleep? There are three reasons that a “rational” person ought not feel bad in my situation.
First, I want to be wrong.
If I could chose the outcome, I would select an enormous and persistent stock market rally. I do not want to see Dow 5,000 as that world would be unpleasant, and probably, unsafe. In Spain and Greece today, for example, the unemployment rate for people under 25 is roughly 50 percent . As much as I love my children, I do not want them to live in my basement after college (especially since in California we don’t have basements).
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Second, I have made money while being wrong.
I have not made a single penny from buying stocks in recent years. However, I have made some investments in very long-term U.S. Treasury bonds (see my article predicting Treasury bond price increases).
Since my Dow 5,000 prediction, long-term Treasury bonds have risen over 18 percent, outperforming the 16.5 percent rise in the Dow Jones Industrial Average (see table below).
I still own some long-term U.S. Treasury bonds even though I now believe that they will be terrible investments. (I plan to write a separate article discussing this apparent contradiction.)
Third, I have not yet been wrong.
I specifically formulated the Dow 5,000 prediction to be neither right nor wrong until the Dow hits hits either 5,000 or 20,000.
So, in some important senses, I ought to be happy about my Dow 5,000 prediction: I want to be wrong, I have made some money investing in an asset class that has done better than U.S. stocks, and I have not yet been wrong.
Why do I feel so bad?
Neuroeconomic and Evolutionary Investing
This is a lesson that goes far beyond me. Recent research extends our knowledge of how and why humans are built to run with the herd. This herding instinct caused us to buy houses in 2007, gold in 2011, and to sell stocks in 2009 (when the Dow was below 6,600).
We seem designed to lose money in financial markets.
Brains Built to Produce Pain
A set of neuroeconomic studies reveals the machinery that causes these problems. Ingenious scientists obtained permission to measure dopamine inside a person’s brain while that person made experimental investment decisions.
The person made decisions to risk a lot, or a little, money on a series of risky gambles. They were then showed the outcome of the gamble along with an updated portfolio value. The novelty in this research is that scientists had placed a neurological probe into the human subject’s brain, specifically to measure the instantaneous release of dopamine in the brain’s reward center. What happened?
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The “investor’s” brain was flooded with dopamine within a tiny fraction of a second after a financial win. Conversely, dopamine levels plunged after losses.
This recent neuroeconomic study is a very precise finding that is consistent with a long line of “stimulus-response” research that goes all the way back to Pavlov and his dogs.
The neurologic evidence is clear: When we make financial investments that lose us money, our brains are built to make us feel bad. Similarly, we get pleasurable dopamine rewards from decisions that turn out well.
Darwin Made Me Lose All My Money
Unlike the factual aspect of neuroeconomic science, the evolutionary explanation for our brain function is speculative. (Some scholars label all such evolutionary stories as ‘just-so’ stories that predict nothing.) Personally, I feel as though the world makes more sense when viewed through an evolutionary lens.
To motivate the evolutionary hypothesis, imagine two of our human ancestors, with unisex names of Contrarian Casey and Momentum Morgan. Momentum Morgan anxiously attempts to imitate others, especially focusing on the “smart” hunters and gatherers (e.g, those with less hairy backs and soaring IQs approaching 75). Contrarian Casey, in contrast, follows idiosyncratic foraging strategies, and particularly likes to do the opposite of the Momentum Morgans.
Imagine further that the momentum approach brings overflowing bounty day after day for years. The Momentum Morgan foragers become so obese that they can hardly drag themselves to their next feast. Meanwhile, lean and hungry Contrarian Casey smugly starves to death wryly quipping about the lunacy of chasing returns.
Who are you rooting for? Momentum Morgan or Contrarian Casey? From an evolutionary perspective, it doesn’t matter who you are rooting for, we all descended from people who succeeded. Did your mom have any babies? What about her mom?
In mathematical terms, the evolutionary hypothesis is that our ancestors lived in a world with positive serial autocorrelation in returns. Without math jargon, this means that yesterday’s outcome provided important information about tomorrow’s returns. Future food was more likely to be found by following approaches that led to past food.
A world where the past predicts the future favors brains that are built to look for patterns.
Even if our herd-seeking instincts were adaptive for our ancestors, they can cause trouble when we use them to invest. The problem is that, in asset markets, past returns provide very little information about future returns.
In academic circles, there is a debate about whether past financial market returns have no information (the ‘Efficient Markets Hypothesis’), negative information (‘price reversal’) or positive information (‘price momentum’). However, all three of these perspectives agree that asset markets have very low levels of predictability relative to other areas of life, both modern and ancestral.
Investing with a Forager’s Brain
What have we learned so far? Our brains are built for a world where the past importantly informs the future. We take those brains into asset markets where the relationship between past and future returns is weak or non-existent. Finally, running with the herd may have helped our ancestors survive and reproduce. So what?
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Our herd running instincts get us in trouble in asset markets, particularly when asset markets go in one direction for very long periods of time. For example, gold was at $875 an ounce in 1979, and roughly $400 in 2002. After this bear market of over 20 years, gold prices then rose every year for more than a decade to a price exceeding $1,500/ounce in 2011. At the historical peak in gold prices in 2011 and 2012, U.S. investors rated gold as the ‘safest’ investment.
People thought gold was a stupid investment at $300 per ounce and loved it at $1,500+ per ounce.
John Maynard Keynes famously said that markets can stay irrational for longer than investors can stay solvent. The neuroeconomic and evolutionary view perhaps adds two new perspectives to a long line of insight about contrarian investing.
First, our brains are built to make it hard to distinguish between “irrational” and “rational” markets. We are not built to recognize mispricings until they are behind us.
Second, emotionally, our brains are built to force us to adapt to the current consensus. That is why almost everyone is wrong at major turning points.
My takeaway message is that pain is necessary, but not sufficient, for investing success.
I have endured 18 months of pain because I have been wrong. We are built to conform, and contrarian positions are deeply unpleasant. The pain I feel is a message from my Pleistocene brain telling me to recognize reality and change my behavior.
However, I stand by my prediction of Dow 5,000 before Dow 20,000. Only time will tell if my stubborn refusal to buy stocks is idiotic or prescient.
The neuroeconomic and evolutionary point is that even I do not know if I will be right or wrong. What I can report with certainty is that not owning stocks sure feels idiotic to me at this moment (Dow 18,019).