Iconoclast: A Neuroscientist Reveals How to Think Differently (16 page)

The expected value of the entire game is simply the sum of the value of each round. Since there are potentially an infinite number of rounds (albeit increasingly unlikely but with payoffs increasing exponentially), the expected value of the game is infinity. Therefore, a
rational person should be willing to pay any amount of money to play this game. But, of course, nobody does.

The fact that people are unwilling to wager anything significant on this game, despite the mathematical rigor of the determination of its value, underscores the fundamentally irrational way that humans deal with risky decisions. This game, known as the St. Petersburg paradox, was articulated by the eighteenth-century Swiss mathematician Daniel Bernoulli, and his explanation of why people are unwilling to play this game forms the basis of the modern economic approach to risk.
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Bernoulli proposed an elegant solution to the paradox. He suggested that the reason people are unwilling to play this game stems from the fact that they don’t value money in a linear manner. To get around this limit, Bernoulli introduced the idea of
utility
. The value of something, be it a new car or a $100 bill, is governed not by its price, but by the utility it yields. Utility is the subjective benefit that a person experiences. The price, according to Bernoulli, depends only on the thing itself, but the utility it confers to someone depends on the individual. This makes intuitive sense. A $100 bill confers more utility to a pauper than to a rich man. To account for this observation, Bernoulli suggested that money has diminishing marginal utility. The more you have, the less utility each additional dollar adds. An extremely wealthy person would experience very little increase in utility from getting more money. This may seem irrational, and it is, but then again, not playing the St. Petersburg lottery is itself an irrational act.

Bernoulli proposed that the utility of money follows a logarithmic curve, which has the property of flattening out the higher you go. If people make decisions about money according to the utility they get, as opposed to the actual face value, then the mathematical logic assumes a different form. Although the exponentially decreasing odds of successive tail flips are balanced by the exponential doubling of the pot, the utility of the pot does not keep pace with the decrease in odds. The
utility of the game is no longer infinite, which means that every person will have some finite price they are willing to pay to play.

It seems like a roundabout way of explaining a quirk of human behavior, but it explained why people seem to have an aversion to risk. There are several definitions of risk, but from an economic point of view, risk is anything where there is a possibility of loss. Playing the St. Petersburg game is a risky decision because someone will lose, either the person placing down the $20 or the person doubling the pot. Bernoulli’s solution was elegant because he said that what appeared to be an aversion to risk stemmed from the way the human mind distorted the value of money. The idea could be extended to anything else that conferred utility based on the quantity consumed—food, for example.

To put risk aversion in the context of the previous two chapters, think of it as fear of failure. Bernoulli said that people look at, say, $1,000 but don’t treat it as ten times more than $100. In other words, their perception of the value of money is distorted. Why should that be? Because they are afraid of the alternative. The fear of losing money, aka the fear of failure, distorts the functioning of the perceptual system in the brain. The end result is, for lack of a better word, an
irrational
decision. Only the iconoclast resists this type of perceptual distortion.

Suppose that you did not distort utility in the manner Bernoulli suggested. Suppose the utility you obtained from a given amount of money exactly tracked the face value of the money. Your utility function would be a straight line, and you would behave in an objective, risk-neutral manner. This is precisely the characteristic that disciplined money managers have. In fact, it is the only way to invest money rationally. It also goes against deep biological biases to behave the way Bernoulli suggested, and it is why there are so few people who can manage risk objectively. How the brain perceives value and utility suggests why most people (and animals) behave this way. But before getting to the neuro side of the story, we must first get to the twenty-first century in terms of economic theory.

By the twentieth century, it became apparent that Bernoulli’s explanation of risk aversion was incomplete. Some argued that people are unwilling to play the St. Petersburg game because to do so would require a belief in unlimited resources available to keep the pot doubling. A dubious assumption in any gambling scenario, especially a bar. But the core idea of utility being the guiding principle behind decision making continued to hold sway. In 1944, the mathematicians John von Neumann and Oskar Morgenstern formalized the idea that
all
decisions could be understood if one assumed that individuals make choices as if they were trying to maximize their utility.
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Von Neumann and Morgenstern said that when an individual is faced with a decision and must make a choice between competing alternatives, the person chooses the course of action with the greatest expected utility. The way to calculate expected utility, or EU, is similar to what Bernoulli suggested. You multiply the utility of every possible outcome by the probability that it will actually happen. Then you choose the action with the highest EU. Expected utility theory, or EUT, explains a great deal about decision making from a mathematical perspective. EUT also paints a clear picture of what is the best course of action to take from a rational perspective, and it remains the foundation of almost all economic models of human decisions.

Despite its mathematical elegance, EUT may strike the average person as a completely unreasonable way to go about making decisions. It requires you to accurately gauge how you will feel about every possible outcome, and calculate the odds of each outcome actually occurring. The vast majority of people, in fact, do not consciously make decisions this way, but recent neuroimaging experiments suggest that the brain does perform calculations similar to this, even when the person is unaware of it. As it turns out, the people who actually do make decisions resembling what EUT predicts are probably the true iconoclasts. Everyone else suffers from a host of perceptual distortions that lead to a cornucopia of decision-making maladies.

The Contrarian: David Dreman

Buy low and sell high. This principle is so obvious, a monkey should be able to make money in the stock market, right? According to David Dreman, a sort of Yoda of contrarian investing, in fact it is this simple. If only you can set aside the fear of failure and the possibility of looking stupid while your peers surpass you.

At age seventy, Dreman has weathered his share of market bubbles and crashes. He has written several best-selling books on contrarian investment, including
Psychology and the Stock Market
and
Contrarian Investment Strategies: The Next Generation
. In addition to his regular columns for
Forbes
, Dreman manages over $6 billion in assets through two mutual funds that adhere to the contrarian principles he espouses. He is the chairman of Dreman Value Management, which, in addition to the mutual funds, manages investments for select institutional and private investors. The Dreman High Equity Return Fund, which is sold through Scudder Funds, has delivered a ten-year annualized return of 11.2 percent, compared with 8.6 percent for the S&P 500 Index. The fund ranks in the top 20 percent of funds with ten-year records.

Dreman’s core principle harks back to the father of investment advice, Benjamin Graham. This investment strategy centers on the idea of buying out-of-favor stocks, hence the contrarian label, and in the world of finance amounts to being an iconoclast. An
out-of-favor stock
, by definition, means that the bulk of the market finds the stock relatively unappealing. According to Dreman, these stocks are easily identified by straightforward measures of valuation. The simplest, and one proposed by Graham seventy years ago, is the price-to-earnings, or P/E, ratio. Dreman looks for stocks that are below the market average P/E and will often buy stocks that are in the bottom fifth.

Dreman laughs when questioned about whether his strategy is really contrarian. He freely admits there is no big secret to his approach. “There
are many good filtering tools to find stocks with low P/E ratios.” But Dreman is quick to add, “But most people don’t do this, even though statistically low P/E stocks outperform over time.” The problem, he says, is that most people, including professionals, can initiate the approach but have trouble following through with it. “The problem is totally anchored in psychology.”
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Actually, it is anchored in the brain’s perceptual systems.

Deceptively simple, the P/E ratio is calculated by dividing the stock price by earnings per share. The P/E ratio represents how much the market values the company relative to what it is currently earning. High P/E ratios imply that the market believes a company will earn more in the future than it is currently earning. In other words, the company is expected to grow. The determination of what constitutes a high P/E ratio depends on several assumptions. If a company is not expected to grow, then it is in steady state. And if it is not growing, a steady-state company can only earn money by carrying on business as usual. The value of a company in this condition is roughly equal to its net operating profit divided by the cost of raising money. If the cost of raising money, through loans and shareholder equity, is 8 percent, then the steady-state valuation is 12.5.
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Thus, as a very rough benchmark, companies with P/E ratios greater than 12.5 are expected to grow in value by finding new customers and new markets. Less than that, the market expects the company to shrink.

Companies with low P/E ratios, those that Dreman hunts for, may have low ratios for two possible reasons. The first is that the company is fundamentally solid, is growing earnings above the market rate, but for perceptual reasons, is out of favor with investors. These are the bargains Dreman tries to find, and according to him, they outperform the rest of the market over the long haul. But not everyone agrees with this sentiment. The second reason a company could have a low P/E ratio is that it is at the end of its life. According Michael Mauboussin, chief investment officer at Legg Mason Capital Management, “Low multiples [P/E ratios] generally reflect low (and justified) expectations.”
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Thus, a
low P/E ratio, rather than being a bargain, as Dreman believes, could signal the imminent death of a company.

Dreman is steadfast in his belief in the low-P/E approach to investment. Eschewing complicated technical analysis, he is also used to wearing the iconoclast label. Raised in Winnipeg, Canada, Dreman had an early exposure to the stock market.
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“My father was a very good commodities person, but he was actually a contrarian,” said Dreman. “So it’s very natural for me.”

Recounting his early professional experiences, Dreman said, “When I was in my 20’s, I was a junior analyst in a Wall Street shop, and I tended to buy favorites. This was really a growth firm, but there was real pressure to buy what everyone else was buying. And this came from the top. I noticed the senior guys would meet their friends at dinners and charities and such, and they all liked the same stocks. It went all the way down the line.

“Now the senior guys,” Dreman continued, “they had strong likes and dislikes. But there was also a belief that if you didn’t stay with these favorite stocks, you’d lose your accounts.” Dreman paused to think about this. “And if you’re an analyst, you might lose your job.”

Referring to the peak of the Internet bubble, Dreman said, “We had a lot of clients in ’99 who moved out of our fund and said, ‘Value is all in the past!’ Some really good value managers quit, and others experienced
value drift
. There was enormous pressure to switch strategies. Even someone like myself, I stayed with it, but I didn’t know if our company would exist. It’s very hard to go against the crowd. Even if you’ve done it most of your life, it still jolts you.

How does someone like Dreman resist the pull of the crowd? How does he resist the fear of standing alone? A calm temperament and self-confidence helps, but what about biological factors? A recent twist in the types of brain imaging studies being conducted has shed some light on the murky area of individual differences. Differences in brain
function may explain why some people have the chops to go against the herd, while others fall in line.

The Iconoclast Who Beats the Market: Bill Miller’s Approach

Here’s the problem with the fundamental value approach: if it really worked, then everyone would use it. And if everyone used it, they would bid up the price of companies believed to be undervalued, and then they would no longer be undervalued. This is why Dreman deserves the label “iconoclast.” Now, many analysts, who make their living analyzing stocks, will argue that by uncovering certain types of information about the company that nobody else possesses, you can gain an advantage in the market. Or by analyzing past trends in prices and correlations between the movement of some assets with others, you can derive algorithms that will outperform the market as a whole. The problem is that everyone has access to the same information. So many individuals are active in the stock market that it becomes extremely unlikely that someone will gain an advantage over the other people. This inability to gain an advantage, in a nutshell, is known as the
efficient market hypothesis
, or EMH.