This may be the last time you trust “reason” in a crowd.

There are many psychological defects that make us do dumb things with money. We chase performance in the stock market and feel pressure from the next house over to buy fancy cars.

If you’ve read any personal finance blog for more than a week, you’ve probably heard some sort of encouragement to “be different” and separate wants from needs, etc., and all that sounds like good advice.

Personally, I’m not so sure it is. Personal finance advice too often focuses on telling you what to do and encouraging you to do it. It sets up the “Do I buy a new Lexus?” scenario as a rational dilemma with a clear answer and path to follow while summarily dismissing wanting to look good in front of the neighbors as the silly purview of broke cattlemen with big hats.

I’m a much bigger fan of avoiding those defects, through using defaults (automatic savings, auto bill pay, auto portfolio re-balancing) rather than trying to counteract the defects will all that positive thinking. This post is meant to show why.

In short, I’m not so sure we can fight the herd.

ABC runs a show called “What Would You Do?” on Fridays. It’s one of those rare shows that’s actually lasted more than a few episodes, but you really only need the plot of one to know how the rest work.

In an episode I saw a few months ago, a few men and women were put through a mock frat or sorority initiation on a public street. The activities were rather extreme with over-the-top physical and verbal abuse. Hidden cameras were rolling to see if anybody would try to stop it or if, instead, people might even join in.

Most people simply ignored the spectacle, one or two joined it, and I can only remember a couple actually trying to stop the abuse. The show, of course, is meant to make all of us think “Of course I would make them stop!” while showing that most people don’t.

To a social psychologist, the show’s probably not surprising one bit. If you put the onlookers alone in a room with the abuse going on, they might speak up, but in a crowd, suddenly all sense of individuality disappears. If the rest of the mob is doing nothing, best to not stand out. If the mob seems OK with an activity, it must be normal to be OK with the activity yourself.

What Would You Do? was a set-up, but there are several infamous examples of the same phenomenon.

You see a murder from your apartment window. What would you do?

In 1964, Kitty Genovese was stalked and stabbed to death in Queens, New York. The murder didn’t happen at once. She was attacked, left to stumble around, and finally killed about an hour later. Neighbors heard screams, might have seen the attacker, but did nothing. A famous New York Times article began with this chilling line: “For more than half an hour 38 respectable, law-abiding citizens in Queens watched a killer stalk and stab a woman in three separate attacks in Kew Gardens.”

Some parts of the story were later discredited, but it’s since been taught in social psychology classes as evidence of the “bystander effect”. A few years after the Genovese murder, John Darley and Bibb Latane attempted to replicate seeming indifference to emergency situations in the lab.

In the Darley/Latane experiment, an undergraduate would be put into a room, alone, with an intercom. He or she was supposed to talk about difficulties of student life with other members of the group (who were supposedly in other rooms, kept private to protect their anonymity). As they took turns talking, one of them would mention that he suffered from seizures. Later in the conversation, the test subject would hear this:

I-er-um-I think I-I need-er-if-if could-er-er-somebody er-er-er-er-er-er-er give me a little-er-give me a little help here because-er-I-er-I’m-er-er-h-h-having a-a-a real problem- er-right now and I-er-if somebody could help me out it would-it would-er-er s-s-sure be-sure be good . . . because-er-there-er-er-a cause I-er-I-uh-I’ve got a-a one of the-er-sei–er-er-things coming on and-and-and I could really-er-use some help so if somebody would-er-give me a little h-help-uh-er-er-er-er-er c-could somebody-er-er-help-er-uh-uh-uh (choking sounds). . . . I’m gonna die-er-er-I’m . . . gonna die-er-help-er-er-seizure- er-[chokes, then quiet].

Seriously. It was in the script.

So guess how long it took the students to, you know, leave the room and tell somebody that someone else on the conference was having a seizure?

First problem: If there were 6 people on the call (subject, victim, and four others), only 31% ever reported it.

Second problem: Even if they did, it took the subject a full 2 minutes and 46 seconds on average after hearing that to go seek help.

If there were fewer people on the conference, the rates and speed of reporting went up. Being in a group of non-doers is was kept people from intervening.

You see someone about to jump off a building. What would you do?

September 2008. A 17-year old, suffering from a bad breakup, threatens to jump from a parking garage. Police negotiators spend three hours trying to talk him down. The crowd acts a bit differently. Here’s a quote from a security guard who was there: “The police did a fantastic job at the incident and were not helped by a baying crowd, some with children, calling for the lad to jump.”

The teenager jumped.

Or how about August 2001. A 26-year old jumped from the Seattle Bridge, after some members of a crowd taunted “Jump bitch jump!” Or February last year, the mob taunted a jumper in San Francisco.

It’d be easy to pass off the cases as meanness or a lack of awareness of how serious the situations were. Part of it, however, is just herd mentality. If someone individually ran across a jumper, he’d probably call the police. Put in a group, that sense of responsibility dissipates. And once one person starts yelling out at the jumper, the rest feel more inclined to do it themselves.

I have the same visceral, disgusted reaction that you probably do. But sometimes I wonder if but for the grace of God, I could have been in that crowd.

(For a great post on the subject, check out You Are Not So Smart.)

And you think you stand a chance in personal finance?

John has a hot stock tip. Everyone at the barbecue nods in agreement.

Mary guilts you into coming to a charity auction. The bidding gets pretty heated.

You hear about money pouring into stocks or gold or whatever. And you wonder if you should come along too.

Or conversely, you feel like too much of your money is at risk in the stock market, but no one else seems to be concerned.

So tell me, what would you do? And are you so sure now that you see even in extremely terrible situations, so many people checked reason at the door and surrendered to the herd?

All the self-motivating, I-can-learn-my-way-out-of-anything things you think are going to bring you to financial fulfillment don’t hold a candle to the deep, deep psychological underpinnings that separate us from the machines.

You’re not going to reason your ways out of these problems. You need to learn why “reason” has nothing to do with them.

And can I contradict myself in a week?

When I was in college, I dressed like a homeless person. Now, I dress like I’m in college. It’s not that I can’t afford nicer clothes. Thankfully I’m well beyond the “no money” years. It’s just that I never really “upgraded” to the stuff most of my peers are wearing nowadays.

So I should be patting myself on the back, right? Living like a poor person—when you’re not—is one of those tried and true personal finance adages that mark classics like The Millionaire Next Door. The millionaires live like they’re not rich. They buy used cars. They eat at home. Then they retire early or spend retirement travelling the world because they’ve saved so much gosh darn money.

But sometimes left out of the discussion of saving, is how much is too much when you’re retirement planning.

To take it to an extreme and keep things simple, let’s say we’ve got a 25-year old making $60,000. He’s totally bought into saving like a madman and maxes out a Roth IRA and a 401k every year until he retires. Based on one, mainstream retirement calculator, that would give him about $8,900 per year per month once he retired at age 66—almost two and a half times what he used to live on at age 65.

He could fund two of his retirements, and still have half a retirement left over. Should we celebrate that?

The concept of “consumption smoothing”

I think most people would say “No.” The 25-year-old self was cheated out of current pleasures…his trip to Norway, his “grown-up” clothes…that would have been perfectly fine for him to buy. Instead, his 80-year-old self either goes on a spending binge, leaves a large inheritance, or tries to pay off St. Peter.

Instead, many economists consider the ideal savings amount to be that which “smooths” your consumption over your lifetime. In short, you want your quality of life in your 60s and beyond to be about as high as it was in your 30s.

At some point and to make things simple, personal finance gurus started to back out savings targets—like 10% or 20%—that would achieve consumption smoothing as long as the stock market hit certain rates of return.

Laurence Kotlikoff, a Boston University economist, a few years ago took it so far as to create an extremely comprehensive retirement calculator, that can show you how much you should consume every year into and through retirement based on the assumptions you put in. (Here’s the more basic, free version.)

Can you save too much for retirement? Yes! But in personal finance circles, it’s generally not “cool” to spend. A recent Wall Street Journal column derided people who buy iPad 2s (or is it iPads 2?). The logic: It’s really costing you $2,000 since you could have invested it instead! By that logic, I should really feel bad about my $5 lunch today—that could have been $20, after inflation, in 2041. This year, I will blow $7,200 of my future money on lunch. I’m such a moron.

The columnist’s logic assigns little to no value to present enjoyment, in favor of future enjoyment. That makes no sense.

Don’t get me wrong, this doesn’t apply to most people. Most Americans will retire with little to no savings. And those people shouldn’t be buying iPads. But given that you’re reading this blog, I’m betting you’re putting at least a bit away already, or at least thinking about putting a bit away.

Throw uncertainty into the mix, and suddenly saving “too much” seems impossible.

The idea of consumption smoothing has a major flaw, of course: uncertainty. We don’t know what stocks will return over the next decades. We don’t know where tax rates will be or if we’ll be in a car accident or if the roof will need to be replaced, etc.

Or perhaps a more dire situation: Imagine you’re a 53-year old staring down the newly proposed Republican budget. In 12 years, you were expecting Medicare. Bzzzzz. Wrong. Maybe you could have seen some sort of Medicare reform coming, but you probably didn’t predict the fairly random age-55 cutoff that would probably allow you to save thousands in insurance costs if you had only been born in 1956.

There are two ways to react to that uncertainty: To save as much as you can in case a worst-case scenario comes along or to save for a best-guess scenario and risk having to cut consumption if the dice come up snake eyes.

I’m saving for a “best guess”, with the reasonable safety measures of a year-long emergency fund, an annuity, etc. Sure, fate could frown on me, but I’m not willing to make a guaranteed sacrifice of reasonable happinesses today just to prepare for a possibly scary future. There’s a chance, my 66-year old self might be unhappy with the current me, but he’s going to have to deal with it.

Or, why I still haven’t bought a mattress

I’ve intended to buy a new mattress for, oh, about a year now. I’ve actually gone to Macy’s and lain down on probably 20 or so mattresses to figure out what I like and don’t like. I’ve looked at reviews of mattresses online, and at one point was pretty close to pulling the trigger.

But I haven’t. This is probably a 10-year investment, and I feel a lot of pressure to make the right choice. So instead I’ve continued to sleep on my too small, cheap Sealy that gets way too hot in summer and is surely less comfortable than even the least comfortable mattress I’ve tried out.

Even if there is a better mattress at a better price out there for me, getting a less-than-ideal mattress is better than the status quo. So why can’t I make a decision?

One problem might be that I simply have too many options to pick from.

In the mid-90s, Columbia professor Sheena Iyengar and Stanford’s Mark Lepper set up a tasting booth with jams at Draeger’s Supermarket in Menlo Park. One day, they set up a booth with a limited selection of six jams. Another day, they set up a booth with an extensive selection of 24 jams.

Customers could sample as many as they wanted, but on average, no matter which booth they encountered, they tried between one and two jams.

The stand with the extensive selection attracted more shoppers than the limited-selection booth, but the limited-selection booth was far more effective in getting people to purchase. In fact, while 30% of shoppers who tasted at the six-jam booth ended up buying a jar, only 3% of shoppers at the 24-jam booth bought one.

In a separate study, they had undergraduate psychology students watch Twelve Angry Men and gave them the option to complete an essay in response to it for extra credit. (The undergrads didn’t know they were part of a study. “Intro to Social Psych” students, take note!)

One group of students could choose from six essay topics. The second group chose from 30 topics. But while 74% of the six-topic students ended up completing the assignment, only 60% of the 30-topic students turned it in.

In both cases, you’d think that having a lot of choices would be viewed by the subjects as a good thing. Indeed, the test subjects reported enjoying making decisions more when they had more to choose from.

But having a lot of choices also made them think more about the consequences of making a “bad” choice or passing up potentially “better” options.

“Maybe jam #15 would taste even better than jam #7! Ah, I’ll just think about it and come back later.”

Don’t let “great” be the enemy of “good.”

There are several theories as to why we can’t make decisions when presented with too many choices. Some people think it’s not the presence of a lot of choices themselves, but the absence of information about the choices. Maybe if those jam-tasters had put all 24 jams in their mouths they wouldn’t have had a problem picking one.

Likewise, maybe it’s so hard to get people to invest because there are seemingly endless companies with which to open accounts and then even more mutual funds to choose from.

But here’s the thing. Investing in any mutual fund is probably going to be better than cash. Your simple stock/bond allocation matters much more than whether you choose the S&P 500 ETF or the S&P Value ETF.

Likewise, almost any mattress will be better than the cheap-o mattress I have. Those jam tasters, assuming they liked one of the jams they tried, would be happy eating it. And those college students who couldn’t pick from 30 topics would have gotten the extra credit had they picked any of them.

Here are some other common “enemy of the good” scenarios I see frequently from myself and others:

— Waiting for the perfect moment to ask for a raise.
— Waiting for the right economic climate or set of personal circumstances to start your own business.
— Waiting for the low-point of the market to start investing.
— Trying to find the perfect diet or workout regimen. In the meantime, continuing to eat ice cream and hot dogs.
— Looking for the right time to change careers and the perfect career to change to (assuming they’re unhappy in their current spot)

In all these scenarios, simply doing anything would probably lead to a better result than doing nothing.

Limit your choices to inspire action.

Let’s return briefly to my mattress problem—which my occasionally aching back and droopy eyelids can attest is all-too-real. What I should have done (and what I should do) is set a scope of research to carry out before making a decision.

So say I decided to visit three stores and then return to my favorite and buy it. Would I get the best mattress ever conceived by man? Probably not. But that’s enough testing to get me to a pretty darn good mattress without leaving endless possible Googling, review reading, and shopping.

In the same way, maybe you can set a deadline for yourself to ask for a raise. If the opportune time hasn’t arisen by, say, May 20th, just ask and get the ball rolling.

Anyway, if you have other ways to avoid decision paralysis, let’s hear them. My back will thank you.

The “crisis” that never comes

The recent deficit talk has people rightly concerned about whether or not Congress and the President have the cojones to bring our fiscal house in order. There are basically four ways to cut the deficit: grow the economy, cut spending, raise taxes, or print money.

Option one is the fun way to get out of it. If we sell more goods and services, government collects more taxes while citizens make more money, and everybody’s happy. However, the economy right now is growing slowly.

Options two and three are where all the debate is happening. However, political risk is frightening most politicians from addressing the beasts of healthcare and Social Security that need to be tamed for any real progress to be done.

Which leaves option four as the default way to pay. If Congress does nothing to fix the deficit, the government can “print money” to devalue those debts, which drives interest rates up and the dollar down. Bad for savers. Good for debtors.

While you might understand how all that could eventually affect inflation and the prices you pay for goods, you might be left scratching your head about just how much of a knock on your savings that last solution could translate to.

Here’s an attempt to explain it without getting too wonky or insulting your intelligence. But first, let’s set one thing straight.

Inflation is not here yet.

I’m kind of tired of the “is there or isn’t there” inflation debate going on right now. The government’s official inflation measure showed that prices rose by about 1.6% over the last 12 months. Food and energy prices accounted for more than two-thirds of the increase.

Inflation of less than 2% is extremely low, especially when you’re including food and energy prices, which swing up and down sharply based on crop yields, hurricanes, etc. Critics like to counter with nice-sounding anecdotes about how their personal grocery bills are rising. But even if we were to accept anecdotal evidence as valid, there’s reason to think those anecdotes are wrong.

Here’s the average grocery store purchase at a Hy-Vee in Des Moines, according to Mint:

Go to Mint’s data feed yourself and play around. Grocery bills aren’t going up. Unless people are eating less, or deciding to make multiple trips to the store in order to keep their average order down (diabolical!), it’s simply not true that grocery prices are already on the upswing.

But it could happen soon. As the WSJ points out today, the prices for some things are rising faster, and inflation is already much worse in places like China, where there’s not a bad economy to weigh against price increases.

I’ve written before about good and bad inflation fighters. But today, I want to write specifically about how rising interest rates could affect stock prices.

Starting with a risk-free rate of return

If you wanted there to be no chance for your investment to lose money, where would you put it? FDIC-insured bank accounts come to mind, but you’d do slightly better by investing in 10-year Treasury bonds, which yield about 3.6% a year right now. Don’t get me wrong. If interest rates rose while you had your bond, the price would go down in the interim. But as long as you held onto them for the entire 10 years, you couldn’t lose a dime unless the federal government were to default.

That’s about as close to risk-free as investors can get right now. And that means that anything they invest in that carries more risk needs to pay out more than 3.6% a year to make sense as an investment.

The bonds of Warren Buffett’s Berkshire Hathaway, for example, would seem to be extremely safe. It’s a big, established company that’s generating a lot of cash. But the yield of a Berkshire bond I’m looking at that matures in 2021 is 4.2%. That means that as safe as Berkshire is, investors want another 0.6 percentage points to take on the ever-so-slight risk that Berkshire goes belly-up before the bond matures.

As you can imagine, once you start getting down to auto companies, those bond yields start to get really high.

What it means for stocks

Stocks also have a yield, though personal finance magazines like to make it appear more complicated than it actually is. The “price-to-earnings” ratio that you read about all the time is really just an earnings yield in reverse. A stock with a P/E of 15, for example, has an earnings yield of 6.7% (1 divided by 15).

Since stocks are more risky than bonds, investors want to pay a price on a company’s stock that reflects the additional risk they have to take on. The price-to-earnings ratio of Berkshire Hathaway, for example is 17.6, which translates into an earnings yield of about 5.7%. (Admittedly, a P/E isn’t the best way to evaluate a holding company like Berkshire.)

So, what happens when the interest rates on Treasury bonds rise? Let’s say the interest rate on a 10-year Treasury bond went to 10%, as it was in the early 1980s.

An investor could earn 10%, while taking no risk, by buying Treasury bonds. So if he considered buying a stock, which carries a lot more risk, instead, he’d want to get a yield that’s better than that.

The earnings yield of the S&P 500 right now is about 4.3% (which is a P/E of about 23). So to get even close to the 10% yield of a Treasury bond, you’d need stock prices to fall by more than half.

In reality, the drop would be much less sharp—earnings would rise, too. But P/E compression, as the phenomenon I just described is called, is a very real fear that investors haven’t had to face for 20 years, since during that time bond rates kept dropping.

Long story short…

If investors fear inflation, and start to demand higher yields from Treasury bonds, that will mean that stock prices will have to make a corresponding drop, all else being equal. Stocks have benefited from a 20-year or so long-term drop in Treasury yields. But that party’s over.

Is there anything you can do to protect yourself from it? Not really. You could choose stocks that already have low P/Es, with the idea that those prices won’t compress as much when interest rates rise. However, buying individual stocks carries so many other risks, that it’s probably not worth your time, effort, or emotional fortitude to go through all that.

It’s just one of those things that you should save more to prepare for and to understand once it does start to happen. This deficit monster is probably going to extend its tentacles into more aspects of our finances than we can even conceive of.

I, for one, am hoarding piles and piles of gold bullion in an undisclosed location. So when Zimbabwe-like inflation causes food riots, I can…eat it…or something.

Making big decisions without much information to go on

Quick game: I have just invented a device that will show me a “face” or a “tree” at random every time I use it. I’m going to use it 16 times, and you’re going to guess the probability that the device will show a “face” the next time I use it.

Ok, here are my results:

1. Tree
2. Face
3. Face
4. Face
5. Face
6. Face
7. Face
8. Face
9. Face
10. Tree
11. Face
12. Face
13. Face
14. Face
15. Face
16. Face

So in total, the device showed 14 faces and 2 trees. Ok, time to decide. Do you think it’s going to show a face or a tree next time? What are the chances?

If you’re like most people, you might have said “a face”! And maybe you would’ve put the probability at 88% or so.

That is, until I told you I was just flipping a quarter from Connecticut.

But now, you might make the opposite guess. The probability of a quarter landing heads or tails is 50%, and Pop just flipped a bunch of heads. That means a string of tails must be coming up, right?

Except it doesn’t mean that. Sure, after thousands of flips, you’ll start to see the balance of heads and tails get closer to 50%, but that next flip has the same 50% of landing on heads as the last flip had.

Thinking it through, we know this. But our “gut” tries to take a small sample size and turn it into a “trend”. With the quarter, it’s just fun and games, but where does this tendency threaten our money?

Starting a business

Around half of small businesses fail. Well, so says the governor of Texas, quoting the Small Business Administration. I can’t find that actual stat on the SBA website—it might be apocryphal. But anyway…

Start-ups are risky. And yet, entrepreneurs take the risk anyway. Is it because they tolerate risk better or because they’re not aware of the risk?

A few researchers from Georgia State University and Oakland University tried to figure that out by having 191 MBA students read a Harvard Business School case study and decide whether or not the subject of the study should quit his job and pursue a theoretical venture.

Granted, these students were “faking” it. They didn’t have to actually feel the pit in their stomach before making the decision to jump or not to jump. Somewhat hilariously, the proposed venture was for contact lenses for chickens. Better eyesight made the chickens fight less, which had financial implications for farmers.

Anyway, the students were asked to pick three important facets of the case that led them to suggest starting or abandoning the venture and explain why. If a student gave a reason that suggested he or she believed in the law of small numbers…that is, that he relied on feedback from a couple customers in the case in making a decision, they marked that down.

It turned out that the students who let small sample sizes guide their decisions were much more prone not to perceive the high risks associated with the venture.

Meta question of the post: Are 191 MBA students with a median age of 28 representative of the risk-attitudes of the entrepreneurial population? Eh.

Picking a mutual fund manager

Pick index funds. Low fees. Blah blah blah…but how do investors actually go about picking a fund? As you might have guessed, they don’t go through the empirical methods they think they do, and it’s true even among “sophisticated” investors.

Take hedge funds, for example. To invest in a hedge fund, you need a minimum net worth of $1,000,000 or an income of $200,000. So, these guys are supposed to know their way around a bank account.

But a couple researchers found that they chase returns like everybody else. Even though funds that perform well do tend to outperform funds that perform poorly (in their sample), investors piled even more money into the funds after a “winning streak” than predicted.

That less-sophisticated investors also chase returns is well documented.

But it’s not all strawberries and cream for index investors. Even our basic assumptions about stock returns are based on a tiny amount of market data.

We have 200 or so years of somewhat reliable market data upon which to estimate how well stocks perform over long periods of time. And let’s say you wanted to show how they tend to perform over 20-year periods, since you’re planning to hold onto your index fund until you retire.

That gives you only ten non-overlapping sets of data upon which to base your retirement decisions. It’s like wagering your life savings on info from the first 16 flips of a face-tree device. Maybe they were representative of the actual probability of stocks performing well in the future, but we don’t really know yet.

It’s going to be impossible to root out “small numbers” from every decision you make in life. I’m still going to go to restaurants and movies that a small sample of friends suggest.

But when it comes to making big decisions, take a little extra time to find as much data as you can, and if the data doesn’t exist, at least be aware that you don’t really know how things might turn out.

Working ourselves up into a frenzy.

Tell me if you recognize this story:

A group of developers begin building entire cities out of nowhere in Florida, putting hundreds of homes where none had existed and billing a “Florida lifestyle” of palm trees, relaxation, and tropical beaches.

As they snap up land, prices rise, and people begin to take vacations to Florida for the expressed purpose of getting in on the land rush. Some don’t even buy homes on the land. They’re content to live in tents.

As the buying continues, Realtors begin to outnumber builders. More buying and selling is going on than actual habitation.

And finally, the market runs out of new customers and the price of land starts to fall precipitously.

Sounds like 2007 and 2008, right? That was actually the great Florida land rush of the 1920s.

But it’s the same story with almost any bubble. At some point, people stop thinking about what the use of the investment is and start buying it based on the hope of rising prices alone.

Precipitating the acceleration of the bubble is our great social echo chamber.

Where the news comes from

Think of the most recent stock market headline you read. It probably didn’t focus too much on fundamentals, like the market’s dividend yield or P/E ratio. Instead it said something about price. Maybe something like “Dow falls below 11,000 for first time since August.”

You can’t really blame the media for it. They’re just telling you what happened, and the P/E is hard to explain when you’ve got 300 words to play around with.

But if you’re like most investors, that probably made you unhappy. Maybe a few thousand investors decided that it was time for them to “lock in their gains” and left the market the next day.

So tomorrow, you might read the headline “Market dips below 9,900 as investors seek safety.”

“Holy cow!” another thousand investors say, this is picking up momentum. A talking head or two on CNBC talks about tax fears or regulation or weak sales or something. Anything to add a rational explanation behind what’s going on, but in reality, nobody knows. Maybe it’s one of those things, but maybe it’s just that the price went down the previous day.

It’s not a phenomenon limited to stocks. There’s a story on CNN.com today about the feedback loop of depression and acne. People become depressed because they have acne, and on and on.

But in finance, you’ll most often hear about feedback loops in how investors tend to feed each other’s fears or euphoria, in a way that makes rational thinking head out the window.

How feedback loops disrupt “rational” markets

One theory of the financial crisis is that triple-A-rated mortgage-backed securities themselves (which were later found to be anything but triple-A) rose to prominence essentially through market feedback mechanisms.

Investors demanded more AAA-rated securities than the U.S. government and corporate world could provide, so banks created them out of the mortgage market. As investors snapped them up, they rose in price, which led to more being created, and so on.

One of the more amusing studies I stumbled across in researching this topic was by Matthieu Wyart and Jean-Phiippe Bouchaud. They posit that some of the common correlations that we see in today’s markets are self-reinforcing. Lately, markets have tended to see stock prices rise when bond prices fall, since investors must be eschewing “risky” stocks in favor of “safer” bonds. Go back a couple decades, and you would have seen stock and bond prices more commonly move in tandem. It’s our recent belief that they should move in opposite directions that makes it so.

So riddle me this: Is this historical P/E ratio of the market near 15 because that’s its natural place in a rational world? Or is it near 15 because we anticipate everyone else thinking it should be near 15 and bid stock prices up or down to reflect that?

If, over a short period of time, stock prices moved in tandem with sun spot activity, would we start to devise rational explanations as to why this might be the case and tie stock prices to sun spots even more closely? I’m being ridiculous of course, but humans do have a tendency to create “stories” to explain phenomena that might just be random.

Getting yourself out of the loop

Spoiler: I think it’s impossible.

Yeah, that’s right. For all my talk of value investing and my occasional forecasts, I have exactly zero dollars devoted to cashing in on any of the phenomena I think I’ve recognized. That’s pretty much because I think I’m just as caught up in the waves of euphoria and panic that plague us as everybody else.

I don’t think turning off the T.V. works. The news is everywhere. In 2000, your neighbor probably gave you stock picks at the local barbecue. In 2007, I don’t know how many friends tried to tell me I needed to buy a house. If you are reading this blog, you are in the feedback loop. I am the feedback loop. (Meta, I know.)

But the best solution I see to making sure the feedback loop doesn’t harm you is to restrict your ability to make decisions based on the loop. I don’t know how many times I’ve been tempted to open a trading account to buy the leveraged short Treasury bond ETF, which would make a lot of money if Treasury prices fall. I’m so sure this will happen.

Right now, though, I’d have to go through a 30-minute or so process to set up this account and transfer money to it, which is enough time to make me come to my senses.

Instead, all my money is in retirement accounts or mutual funds bought straight from Vanguard, which has a brokerage option that I don’t have set up. (I don’t think it’s set up. I’m afraid to look lest I discover it is.)

So the key, I think, is to be in the loop but have no power to act on the information you get from it.

Steps I’ve taken to save me from myself:

1. The aforementioned lack of a brokerage account.

2. I cripple my own confidence in my stock picking abilities. No seriously. I go out of my way to read hundreds of books and articles about how bad we are at making rational decisions. If that doesn’t lower your confidence level, I don’t know what will.

3. I have no dry powder (for investments). I have an emergency fund, and hopefully the temptation will never arise to use it for something other than an emergency. But other than that, I just don’t have a lot of cash to burn on a stock pick. So even if I did think I saw a great investing “opportunity”, there’s nothing I could do with the information.

I know this contrasts with advice you might have read elsewhere, maybe even here, but what good is dry powder when we’re so bad at putting it to use? I’d rather keep my money safe from myself in an index fund.

If you take anything away from this, I hope it’s that you can’t help being afraid or ebullient based on other people’s emotions. But that doesn’t mean those tendencies have to hurt you.

I’m not one to do round-ups…

…but over the last couple months, I’ve gotten a dozen or so e-mails asking about investing and behavioral economics and where to read more about it. One of the problems with learning about this stuff is that unless you’re still an undergrad, it might seem like you missed your chance to learn about these topics. Nothing could be further from the truth.

In fact, unless you went to school within the last decade or so, there’s a good chance you wouldn’t have even had a behavioral economics course on the menu. How emotions sway economic decisions was just a footnote in a larger, rationally-governed framework of how markets work. It’s just the crashes of the dot-com and home markets that got everybody interested in the things that seem so obvious now.

Luckily, there have been a bunch of economics books that try to explain how investing and behavioral economics works to lay people, and I’ve read many of them. But the thing is, I only keep one bookshelf at home, so most investing and economics books are given away. These are the ones that never left that shelf.

This is definitely a reading list meant for people who already know something about the stock market. If you’re really starting from a blank slate, check out Understanding Wall Street by Jeffrey Little and Lucien Rhodes. However, if you’ve been reading personal finance blogs for years and feel like you never learn anything new, check these out.

Laying the foundation of investment knowledge

The Intelligent Investor: This has been referred to as the “value investor’s Bible” and the title is deserved. In it, Benjamin Graham, a former Columbia professor and the mentor of Warren Buffett, outlines his value-investing philosophy. Graham understood behavioral economics even though he didn’t articulate it in the same way we do today.

The book won’t teach you how to analyze specific stocks, but does teach you about the basic emotional problems lay investors run into and outlines an investment philosophy that emphasizes sustainable gains and avoiding losses. The notes are by journalist Jason Zweig and, especially for new investors, are a must read.

Security Analysis: This is also by Benjamin Graham, though I don’t recommend reading it unless you’ve read the Intelligent Investor and understand it. Security Analysis answers all those questions that were raised by the Intelligent Investor. Now that you have an investing philosophy, how do you go out and evaluate actual stocks and bonds that are on the market for sale?

Fair warning: It’s long, and it’s dense. You need a fair amount of investing knowledge just to understand what Graham, and his colleague David Dodd, are writing. But if you do get through it, you’ll have an incredibly deep understanding of investing. Markets are a lot different today, but this is a great foundation to build upon.

The Essays of Warren Buffett: Warren Buffett hasn’t written a tell-all investing book. Maybe he’s saving that for when he retires. Instead, he’s written a series of letters to the investors in his company, Berkshire Hathaway, that value investors have mined for investment wisdom for decades. Let me be clear: You can get nearly all the materials in this book for free, right here. What you’re paying for is a good editor to order more than 30 years worth of material in a way that can increase your investing knowledge without having to sort through extraneous detail or the repetition of points that Buffett likes to use every year.

Homing in on behavioral finance

Irrational Exuberance: Now we start to get into behavioral economics and our emotional reaction to money matters. Yale professor Robert Shiller published the first edition of this book right as the dot-com bubble was cresting and gave his theories as to why prices of companies continued to rise even in the face of small or non-existent profits. The second edition adds info on the real estate bubble and its similarities to the crisis from just 10 years before. It’s easy to recognize bubbles in retrospect, but this guy did it twice before they popped. That there hasn’t been a third edition talking about gold makes me concerned that I might be wrong in my continually bearish view on that one (kidding).

The Black Swan: Awareness of ones own ignorance is powerful. In this book, Nassim Nicholas Taleb explores humans’ propensity to assign “reasons” for events, when simple randomness might explain them better. His philosophy could be summarize in two sentences: Just because you’ve observed many instances of something, it doesn’t mean it will happen again. And just because you’ve never seen something before, it doesn’t mean it couldn’t happen. His writing style is pretty arrogant, but if you can tolerate it, you have a good chance of avoiding investors’ biggest pitfall: overconfidence.

Predictably Irrational: I’ve used the work of Duke professor Dan Ariely as fodder for a number of blog posts and with good reason. As “pop economics” goes, Ariely is one of the best. His books neatly tie-up behavioral theories, like why we’re willing to pay certain prices or items or sometimes prefer paying to free, as told through experiments on his hapless college students.

That’s it. I know there are a lot of other books out there that are worth reading and that I’ve enjoyed myself. I know some of you might be surprised I didn’t keep Freakonomics by Steven Levitt, which is a fun look at how previously unexplainable phenomena might be explained through statistical analysis. But as I’ve continued trying to downsize the “stuff” I have sitting around the house, these are the only ones that haven’t bitten the dust. Hope you find them useful too.

Note: You might have noticed I didn’t post yesterday as I’m supposed to. I admit it. I blew it. Part of the learning process I guess. Also, those are all affiliate links.

This could probably apply to a lot of markets.

I’ve written too many times about all the reasons I’m not a fan of gold as an investment, even if it’s only a part of a diversified portfolio. I know, I know— “It’s a currency of last resort.” Or maybe, “It’s always been a store of wealth in times of inflation.” But something doesn’t strike me right about an “investment” whose only purpose is to wait for the next buyer to come around.

I’ve written that a bunch of times. So with this video send-off, I promise not to write about gold until next year. This was created using a text-to-speech moviemaker called Xtranormal. I’d be generous if I called it b-movie quality.

Obvious hat-tip to Warren Buffett, and the numbers in here were based on an estimate of how much gold exists in the world that I found on a rather random website. So take it with a grain of salt.

You’re never going to learn to invest in individual stocks from reading this blog.

Says the beginning of a Wall Street Journal story today: “Forget ‘buy and hold.’ It’s time to time the market.”

Awesome. That’s the kind of provocative, yet easy to knock down, straw man that blog writers salivate over. I could pull up dozens of market-timing studies that show how much investors suck at it. I could make my oft-repeated argument that even though value investing should work, in practice, we’re too emotional to make it work.

This time I want to tackle something different, that is, the actual strategies people use to pick stocks and sectors. The WSJ story talks about a few common ones, such as picking companies with high dividend yields and low price-to-earnings ratios. They’re easily to calculate—but hey, why bother? Just look them up on Google or Yahoo Finance.

The truth is, they’re not a bad place to start. But how would you actually do by following any of these strategies?

Good investment or bad investment?

Let’s play a game. I’m going to describe a company stock from a few years ago using some favorite investor metrics, and you guess “good investment” or “bad investment” over the next three years.

Company A has a P/E ratio of 8. That means you could buy a share of its stock, and get a whopping 12.5% earnings yield. It also has a 2.4% dividend yield. The stock just lost a huge $30 billion in market capitalization, which means investors are running for the hills. But as Warren Buffett says, we’ve got to be greedy when others are fearful, right?

Company B has a P/E ratio of 23. It has no dividend yield. The stock’s risen 22% in the last four months. Pulling from the second part of that Buffett quote, you’ve got to be fearful when others are greedy, right? One of its main lines of business, insurance, has benefited from a spat of very good weather, keeping its profit margins high. But that hurricane’s got to come sometime.

Answers

Company A was Merrill Lynch. You bought at about $60 per share. If you held on until it was sold to Bank of America, you would have gotten out at about $29 per share for a 50% loss. Honestly, you would have been lucky. That deal, which was a 70% premium to its market price, left a lot of investors scratching their heads. Had Bank of America not stepped in, Merrill might have ceased to exist in a few days.

Company B was Berkshire Hathaway. You bought at about $99 per share (split adjusted for the B shares). If you’re still holding on, it’s worth about $80 per share now. It’s a 20% loss (hard to find a company that hasn’t lost money since 2007), but not nearly as bad as what you would have experienced with Merrill.

The other thing the companies had in common was that they were picked as two “Best Stocks for 2008” in Fortune Magazine. I don’t mean to pick on that reporter. Pretty much the only way he would have been right was if he wrote “None of them!” in big, capital letters.

Knowing just enough to hurt yourself

Based on traditional rules of thumb about dividend yields and P/E ratios, Merrill should have been the better buy. Alas, it was not. Is that really all that surprising?

Say your brother came to you and asked you to invest in his business. He said the business was making $10,000 per year, and he was willing to sell you a piece for $100,000. He’ll pay out $5,000 per year to you and other investors. That’s a P/E of 10 and dividend yield of 5% for your $10,000 investment.

OMG, give me a million shares, right? RIGHT?!

Well, no, actually. You want to know more about the business. Who are the competing stores nearby? Does he owe the bank any money? Are sales growing? Falling? Who else is running this business with your brother? Do they have good character? And on, and on.

Investing that much money based on a simple investing strategy in your brother’s business seems crazy. However for some reason, we don’t blanche when just a couple simple metrics are used to determine investments in the tiny pieces of companies that we call stocks.

That WSJ article from the beginning of this story? Its given “strategies” include to buy stocks that have boosted dividends lately and to buy the 10 largest technology companies by market capitalization. Those are easy to package and write about. But an investment strategy? That’s taking it a little far.

The real problem with learning about investing

Which leads us to the real problem that a little information creates: Overconfidence. Before you started reading Pop Economics and the Wall Street Journal and SmartMoney and all those other sources that teach you just a little bit about investing, you didn’t know anything about stocks, and were willing to cede control to index funds or a financial advisor.

But now, you know something about stocks. It’s like a teenager learning to drive. When he was 3, he didn’t know how to turn on the car. Now that he’s 17 and behind the wheel taking lessons, is that car more or less dangerous to him?

So anyway, all that’s to say, read PopEc at your own risk. I hope you come away from most of my posts with a new understanding of how much you don’t know. I know that’s how I feel after writing them. Heck, I don’t even remember what this post was about.

Let’s make a quick comparison.

This is a short post, and I’m sorry about that. For reasons apart from my work here, this has been a week from hell.

Remember how the world felt before Lehman Bros. collapsed? Bear Stearns had gone down, but some economists still thought it might just be a short downturn. An article about a month before the collapse concluded: “Is the worst over? Maybe, now that the largest possible victims seem to have been saved.”

The victims it’s referring to are Fannie Mae and Freddie Mac. They and most people didn’t understand how deep the ramifications that even a relatively small failure—Lehman’s market cap before failing was roughly a third of Fannie and Freddie combined before their takeover—could have.

Lehman turned all those forecasts on their head. It turned people from pessimistic to scared. For me, as I’ve written, the effect hasn’t really worn off. But what does the market say?

Pre-Lehman Brothers collapse

Unemployment rate: 6.2% (September 2008)

Per capita GDP: $47,464 (third quarter 2008)

Dow Jones industrial average: 11421 (closing price on Sept. 12, 2008)

Now

Unemployment rate: 9.6% (October)

Per capita GDP: $47,449 (third quarter 2010)

Dow Jones industrial average: 11,444

Sources: BEA, BLS, Morningstar

See any problems here? Granted, a lot more goes into stock prices than the two metrics mentioned. And heck, per capita GDP isn’t even that far off of where it was in 2008. But with unemployment sitting several points above where it was before the Lehman collapse, and people decidedly less optimistic about the economy’s next few years, it seems pretty surprising that the Dow managed to pass its pre-financial crisis level earlier this week.

So do investors have it right? I generally don’t advocate changing a stock allocation based on current events—you’re way too susceptible to emotions that cloud rational thinking. But sometimes it’s fun to take a stab at optimism when it seems to be getting out of hand.

First, some bad news: Average Joe investors are warming up to stocks again. Over 23 weeks, investors had pulled $92 billion (net) from stock funds. But just a couple weeks ago, stock funds broke that losing streak. It seems investors are finally losing their fear of stocks, which as a contrarian indicator, isn’t good.

Putting individual investors aside, it’s amazing that the stock market indicates that we’re back to the stage we were pre-crisis. Even though the economy has returned to expansion—on a non-per-capita basis, GDP is actually above where it was two years ago—it surely seems like the psychology of all those people we expect to buy things and invest in the country is damaged.

Sure, profits are at record highs again, but a lot of people think that’s because businesses are holding off on hiring and making new investments, which makes profit margins great in the short run but stunts growth in the long run.

But hey, what do I know that the market doesn’t?