Chicken Little and the Art of Investing

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By AJ Cilliers*

Early August marked the first anniversary of the credit crunch. The infant that arrived unheralded and unwelcome on the doorstep of the financial world is now, believe it or not, just over one year old. While we all hoped that its unhappy life would be a short one, it now seems as though this unwanted foundling is going to be with us for a while yet. And, by all accounts, it is going to cause us a lot more sleepless nights before it goes away.

If the credit crunch were a storm we might now be in its eye – that expanse of uneasy calm in the storm’s centre, which whispers to the unwary that the worst is behind them. No chance, I’m afraid, if we listen to the utterances of those in high places. For example, former IMF chief economist Ken Rogoff warned recently that the credit crisis in America is only half over: “America is not out of the woods … The worst is yet to come,” he said. Rogoff also predicted that bankruptcies would not be confined to mid-sized banks – “we’re going to see a big one collapse in the next few months,” he warned.

It is not difficult, in the midst of this media barrage, to accept that this financial crisis is going to be worse than anything most of us have experienced in our lifetime. As desperate times call for desperate measures, what action should equity investors take in the face of this “perfect storm”? I read far and wide in search of an answer, and spoke to those in the financial services industry whose opinions I respect. The answers I got were not those I expected when I set out on my quest.

If you will indulge me, I would like to enlighten you in part by way of a parable. It tells the tale of Chicken Little, and the abbreviated version goes like this:

Chicken Little was walking through the woods one day when an acorn fell on her head. It scared her so much she trembled all over. She shook so hard, half her feathers fell out.

“Help, help! The sky is falling! I have to go tell the king!”

So she ran in great fright to tell the king. As she rushed along, one by one she came across a number of her friends – Henny Penny, Ducky Lucky, Goosey Loosey and Turkey Lurkey. To each one of them, in turn, she cried out:

“Oh help! The sky is falling!”

And each one in turn asked: “How do you know?”

“I saw it with my own eyes, and heard it with my own ears, and part of it fell on my head! I am going to tell the king!” said Chicken Little.

Each of her friends agreed that this was terrible news and joined Chicken Little on her mission, all of them running as fast as they could down the road.

Before long the rushing group met Foxy Loxy, who greeted them with a friendly smile and said: “Well, well. Where are you rushing on such a fine day?”

Chicken Little explained that it was not a fine day at all. The sky was falling, and they were running to tell the king.

“I see,” said Foxy Loxy. “Well then, follow me and I’ll show you the way to the king.” *

So they all followed Foxy Loxy, across a field and through the woods, straight to Foxy Loxy’s den. And none of them ever saw the king to tell him that the sky was falling.

To understand this parable in its financial context, we need some more information. Ponder this, if you will:

(1) In the 12 months following the terrorist attacks of 11 September 2001, many Americans chose to drive rather than take domestic flights. As a result the number of people killed in road accidents over that year rose by about 1600. This was six times the number who died in the hijacked aircraft.

(2) George Loewenstein, an academic at Carnegie Mellon University in Pittsburgh, Pennsylvania, who teaches decision-making, recalls how after 9/11 an economist colleague of his whom he had always considered “a paragon of rationality,” chose to drive rather than fly to distant meetings.

“Rather than deliberating about a long-term strategy to counter a risk, people often seem to go into panic mode and take actions that actually exacerbate the problem they are worried about,” Loewenstein says.

(3) Crime rates in the US fell by 20% between 1990 and 1998. However, the majority of residents believed that crime had increased during this time. During this particular period, TV coverage of crime in the U.S. rose by 83% while, more significantly, coverage of homicides rose by 473%. The actual number of homicides fell by 33%.

If you are totally confused by now, please bear with me. There are a few factors at work here that will help to make things clearer: (Numbers (i) to (iii) below refer to points 1 to 3 above).

(i) We are bad at making good decisions in risky situations. The key to this lies in our emotional response – when we are distressed or otherwise emotionally aroused, we seem to be incapable of soberly weighing up our options. Instead, we are led by our feelings.

(ii) In emotionally charged circumstances, few people want to check the evidence. For instance, Michael Sivak and Michael Flannagan of the University of Michigan have determined that driving the length of a typical domestic flight in the U.S. (estimated at 1,157 kilometres) is 65 times riskier than flying.

(iii) The disproportionate reporting of dramatic events distorts decision-making when it leads to an “availability cascade.” This is a process which makes a story more believable as more and more people accept it as fact, and retell it as such. Cass Sunstein at the University of Chicago Law School and Timur Kuran at Duke University in Durham, North Carolina, explain that availability cascades stem from the fact that people have limited knowledge about most things. As a result, each of us depends for information on what other people seem to know.

This is a particular danger when “other people” includes the various forms of the media, who all beam out the same story, often in a sensationalized and distorted manner.

We can now use this information to help us interpret the lessons that the Chicken Little story can teach us. To begin with, we can liken Chicken Little to the media – when a relatively minor event occurs, she over-reacts and believes that the sky is falling. Each of her friends who hear the news reacts with an emotional knee-jerk reaction, and does not stop to rationally examine Chicken Little’s claim. As the news spreads and the group grows, (the “availability cascade”) each subsequent bird met along the way is swept along on the emotional tide. Finally, only Foxy Loxy makes a rational analysis of the situation, and the birds come to an unfortunate end.

I have to admit that the credit crunch media storm had me reacting the same way. In these once-in-a-century circumstances, how should we react? Should investors move out of equities and into bonds? And should these be corporate or government bonds, or both? I asked one of my trusted financial services friends, a man who manages a number of large equity portfolios for various high net-worth individuals, what he was going to do in the face of this disastrous event.

His answer was simple: “Nothing”.

In reaction to my slack-jawed expression of amazement, he explained that he followed a value-investment strategy. When I suggested that markets might crash and that bonds might provide a safe haven until the storm was over, he merely smiled indulgently. A crash, he explained, would provide opportunity for further equity purchases – the last thing he wanted was to be out of the market, unless I could tell him exactly when the crash and subsequent upswing would take place. (The classic error of trying to time the market). He was going to stick to his value-investing principles, re-balancing his clients’ portfolios according to a previously agreed timetable, and actually increasing their investments as the market declined and earnings and dividend yields improved.

He is right, of course, and his advice serves to emphasise how careful we must be to avoid an emotion-driven, knee-jerk reaction in the face of seemingly cataclysmic events. As George Loewenstein put it earlier:

“Rather than deliberating about a long-term strategy to counter a risk, people often seem to go into panic mode and take actions that actually exacerbate the problem they are worried about.”

Warren Buffett agrees. In his introduction to the fourth edition of Benjamin Graham’s value-investing classic, The Intelligent Investor, Buffett says:

“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”

Buffett goes on to say: “Whether you achieve outstanding results will depend on the effort and intellect you apply to your investments, as well as on the amplitudes of stock-market folly that prevail during your investment career.”

This final point is re-emphasised in the tribute to Graham which Buffett wrote in The Financial Analysts Journal in 1976, shortly after Graham’s death:

“In an area where much looks foolish within weeks or months after publication, Ben’s principles have remained sound – their value often enhanced and better understood in the wake of financial storms that demolished flimsier structures.”

This is not to diminish the possible severity of the credit crunch, or the recession which very well might follow. But at the end of the day, most good companies will survive. Their share prices may fall during the recession, but if history teaches us any lessons it is that those share prices will rise again above their previous highs.

It is a time for cool minds and a proven strategy – not the time to panic, or to be a little chicken!

Source: A.J. Cilliers, Sharenet, October 2008.

*AJ Cilliers is a Senior Lecturer in the Department of Accounting at the University of Cape Town, specializing in Managerial Accounting and Financial Management. AJ held senior accounting and financial management positions in a number of well-known South African companies, before joining UCT some five years ago. His current areas of interest include the valuation and management of investments, value-based management, and the emerging field of behavioural finance. AJ is also a life-long student of personal development, and is bound to share this passion with you in the months to come!

 

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7 comments to Chicken Little and the Art of Investing

  • Lawrence

    If it were $100,000 that hit Chicken Little on the head he would be about smart enough to put it in the stock market!

  • Dave Tapson

    (1) In the 12 months following the terrorist attacks of 11 September 2001, many Americans chose to drive rather than take domestic flights.

    I can’t help but think that scorning this fact smacks of hindsight vision being 20/20. When planes are falling out of the sky, it doesn’t really make sense to go and get on them – until experience shows that the’ve stopped falling out the sky. I’m sure there is someone somewhere who can do the sums and figure out that this is actually a rational course of action…

  • Paul Sandison

    Lawrence is correct. If you have an extra $100 000 you can play with it. If you are Warren Buffet and do not depend on your capital for enough annual return to be able to buy your food and have a roof over your head, then you can be more dispassionate about making long-term investments now. In a recent video interview Warren Buffet hinted that even if there were many more troubles to come, Berkshire Hathaway’s purchase of GE would be OK long-term. i.e. on the other side of the trough.

    AJ Cilliers’s investment manager has the same approach, and that is understandable if one has enough money to survive on in the meantime – something that he and Warren Buffet evidently have. But most investors do not have the time to wait. It took 26 years, i.e. until 1956, for stock market values to return to what they were in 1929. Few people on the planet can wait that long. So the first question is: do you invest for fun, or is it your nest egg or your retirement funds you are managing?

    The next thing that most people don’t have is Warren Buffet’s training and ability, otherwise the world would be filled with millions of brilliant gurus and genial fund managers, and it isn’t. Despite his tips and books, his approach does not fit the circumstancs of ordinary people because they do not have reserve funds to play with, are not a 20 year old starting out like Buffet did in his youth, have demanding jobs to do and cannot spend the time involved in becoming a company analyst.

    Ordinary mortal people have to look at things like how bad does the present crisis appear to be, what appears to be involved, what is likely to fail, and compare that picture with how such crises have played out in the past and discuss the differences and similarities. If reality was not like this for most ordinary people there wouldn’t be runs on banks, and there wouldn’t loads of ordinary investors still holding shares today, after a 40% fall on most Western stock markets, due to an investment approach based on hope or bad advice.

    What is lacking from present discussions all over the world is a proper analysis of the possible time frame for the present crunch. We know the US mortgage resets are going to go on through 2012, and thus the defaults will continue to occur up until end of 2012. Therefore, surely everyone needs to get real: the credit crunch is not going to stop completely before that time is out. So although is is emotionally painful to try and look at the facts coldly and dispassionately, the fact is the credit crunch is not going to go away anytime soon.

    Henry Paulson and so many others have been very insistent on this last point, simply because so many people desperately want to believe that his bank rescue package will put a floor on the market. It won’t. The point of the ‘Chicken Little’ story is indeed to look at the facts, not put your trust in some fox who promises to save the day for you. Henry Paulson certainly does not want to be accused of being the fox in the story later on, and that is why he is openly warning everyone that the present rescue package is not the end of the crisis.

    His comments leave the duration of the crisis open-ended. But most people plan their lives along a linear time scale, and most people want to know what is going to go down the tube because they do not want to invest in something this year, next year or the year after that, which then suddenly crumbles and dissipates into thin air.

    Most people would now agree that this crisis is the most serious since the 1930s, i.e. the Great Depression. When they say that it means they don’t know yet whether this crisis is going to be as big or perhaps even greater than the Great Depression. It certainly doesn’t look too easy to judge at this point in time.

    As an investor it is always important to watch for the approaching top of the cycle and the bottom, to know when to get out and get back in. If of course you have friends in huge investment and insurance companies who tip you off about which sectors they are going to go into that day or season in order to drive up the price before they pull out, leaving the newbies in free fall, then you can get in just before they go in and get out just before they get out. Investing is far easier and some would say a piece of cake. There may also be other large players around doing similar things on the same day which might cloud things a little, but in general the game is predictable, some would say almost boringly easy.

    On one’s own, timing becomes extremely difficult, and scornful stories abound about silly people who try to time the top or the bottom, just like there are loads of childrens’s stories about disobedient children who were warned not to skate on Farmer Jones’s pond, and did, and drowned. But these stories should not mean that one should never try to learn to skate, or learn how to test the depth of the ice before one gets on it. Frankly, the scornful stories also do the market a disservice by dissuading people from investing at all. If one never tries to investigate whether a market is going up or down, is near the top or bottom, then one would be a gambler if one merely closed one’s eyes and picked out a stock or a fund and invested in it. Most people are not so stupid as to go along with that. There are better things like horse races for openly risky gambling. Also, if it wasn’t important to try and fathom the top and bottom of market cycles, there would not be any technical market analysts in the world today. So the warning of never ever trying to judge the top or bottom of the market is simply opaque and unhelpful.

    To the question of time-frame which might give a hint of how far the downward cycle has to go: if we are looking at the stock market fall as a measure of the Great Depression (leaving aside for the moment that there are many other indicators as well), then surely one should try not to get transfixed and rely only on hope that the market has now hit bottom and will begin to rebuild. For if the crash after the Nasdaq twin peaks took about 3 years to hit bottom and the crash after 1929 took about 4 years to hit bottom, then they beg the question: why should the present downturn be any quicker than that?

    The problem I have with the advice A J Cilliers’s investment manager gave him is that it is perfectly reasonable to believe the stock markets are only roughly half way down and I am not a company analyst who can tell which companies are sturdy enough to survive a possible Great Depression. So to get in to the market now means possibly suffering enormous losses until the market hits depression levels of about 20% of their present values.

    Even if the companies I buy shares in do survive long term, going on the Great Depression pace of recovery, it would take at least half of 26 years, i.e. 13 years, for them to return to the value at the present time of investment in October 2008. If this crisis is any different to the Great Depression, I want people to tell me why it is different, and how that makes a difference to any investment advice at this point in time. A related question is when will Nasdaq return to the levels seen in 2000? What is it that prevents value being restored to stocks that have undergone an inflated peak, for almost 3 decades?

    From history we know that the Great Depression was preceded by a housing boom, and the Great Depression was characterised by a collapse in the banking system because people borrowed money to buy shares. We have the same two problems today. However, one marked difference from 1929 is that we now have derivatives, and the unknown effects of these derivatives being traded in a $62bn unregulated market which far outstrips the values on the world’s ordinary stock markets. Warren Buffet is totally against derivatives but some people defend them as assisting the function of the markets.

    So, are derivatives going to dissolve the crisis for us or make it infinitely worse, or is their effect neutral in this context? These questions must be satisfactorily dealt with for any evaulation of the time frame and depth of the present downward phase, and therefore for any advice on when to invest.

    Overall therefore, the fundamental questions remain. Is the credit crunch going to on until the last terrible fall on 24th October 2012 creates a final overshooting bottom, or is it going to go away much sooner? If you find the suggested date of the 24th October 2012 disturbing, e.g. way too far ahead, and want to reject it, what are the concrete reasons why it is not perfectly possible as a date for the nadir of the crisis? If you are an investment guru, the date and depth of the final bottom is not crucial and you can invest long-term like Buffet, so the precise date won’t concern you. However I think that if you are managing your nest egg or your retirement funds, the only two things you can invest in while the markets plumb the depths for such a long time are precious metals because they hold value during a depression, or a plot of very arable land to farm in order to feed yourself during the lean years. What do you think?

  • The Ace Chase

    This is erudite. One thing not mentioned that I find paramount is the inevitable high inflation that will result from the massive amounts of money being introduced around the world. A return to the gold standard is not impossible, and, in any event, the price of gold should skyrocket. The sudden shortage of gold coins shows that, indeed, “You cannot fool all of the people all of the time.” Thanks again for the great information every week. JRC

  • SA

    If a person claims that he can buy value stocks at this point of time and give example of Warren Buffet and Benjamin Grahim, what he misses is that Buffet is not taking a big bet on S&P 500 instead he is getting superbly crafted deals from the best firms in their respective businesses. It is pretty evident that the guy is not managing his own money but only of some clients. He has not felt the pain himself. Value Stocks do go bankrupt ( think Lehman, AIG ), people have been buying these world class firms all the way down.

  • Jean Ross

    This article is about sticking your head in the sand. It took 25 years for the Dow to break through the high of 1929. If you haven’t sold at least some of your portfolio by now to raise cash so to invest at lower levels you may regret your decision.

  • Frank Wordick

    Cilliers’ article could aptly be titled “Anatomy of a Paralyzed Bean Counter”. Recall how Baruch marveled about investors who knew what to do, but were unable to do it. Cilliers’ is one of the worst sorts. He knows what to do, but chooses to ask an incompetent investment advisor his advice and then, instead of rejecting it and following his own inclinations, chooses to follow it. Of course, by this point the damage has already been done. You can’t get your money back. The time to have moved was after the market topped out. Mauldin and other knowledgable advisors had been barking for months warning everyone about the imminent collapse of the market. One other thing: How much longer do you think this incompetent boob of an advisor is going to be in business? Do you think that multi-millionaires like to lose half their meld? These people even collect Social Security checks. Wait till they get their quarterly reports.

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