Buffett and the Folly of Human Nature

In 1979, Warren Buffett wrote a telling piece in Forbes entitled “You pay a very high price in the stock market for a cheery consensus” about the folly of human nature when it comes to investing. Buffett’s point was that many investors seem almost “hard wired” to take actions that are not in their best interests.

“Pension-fund managers continue to make investment decisions with their eyes firmly fixed on the rearview mirror. This generals-fighting-the-last-war approach has proven costly in the past and will likely prove equally costly this time around.

Stocks now sell at levels that should produce long-term returns far superior to bonds. Yet pensions managers, usually encouraged by corporate sponsors they must necessarily please (“whose bread I eat, his song I sing”), are pouring funds in record proportions into bonds.

Meanwhile, orders for stocks are being placed with an eyedropper. Parkinson–of Parkinson’s law fame–might conclude that the enthusiasm of professionals for stocks varies proportionately with the recent pleasure derived from ownership. This always was the way John Q. Public was expected to behave. John Q. Expert seems similarly afflicted. Here’s the record.

In 1972, when the Dow earned $67.11, or 11% on beginning book value of 607, it closed the year selling at 1,020, and pension managers couldn’t buy stocks fast enough. Purchases of equities in 1972 were 105% of net funds available (i.e., bonds were sold), a record except for the 122% of the even more buoyant prior year. This two-year stampede increased the equity portion of total pension assets from 61% to 74%–an all-time record that coincided nicely with a record-high price for the Dow. The more investment managers paid for stocks, the better they felt about them.

And then the market went into a tailspin in 1973-74. Although the Dow earned $99.04 in 1974, or 14% on beginning book value of 690, it finished the year selling at 616. A bargain? Alas, such bargain prices produced panic rather than purchases; only 21% of net investable funds went into equities that year, a 25-year record low. The proportion of equities held by private noninsured pension plans fell to 54% of net assets, a full 20-point drop from the level deemed appropriate when the Dow was 400 points higher.

By 1976, the courage of pension managers rose in tandem with the price level, and 56% of available funds was committed to stocks. The Dow that year averaged close to 1,000, a level then about 25% above book value.” (continue reading)

The more things change, the more they stay the same. An article in today’s Wall Street Journal entitled “Rally Spurs Stocks to ’09 Highs” quotes Kevin Mahn, Managing Director & Chief Investment Officer of Hennion & Walsh. Mr. Mahn said, “Institutional and retail investors are so anxious to make up the lost returns of the last year, they are using any cue to buy aggressively. We got to the point in the first quarter, when everyone was so risk averse they lost out. And, in just six months, they have now become overly aggressive.”

As I wrote in the Comments section at WSJ.com, “It never ceases to amaze that many people would not touch stocks that were “screaming buys” just four months ago. Now, the same people are clamoring to get in after these same stocks have made massive moves to the upside – many over 100%.”

Takeaway: Learn to think properly about market prices. Faulty, self-defeating behavior can be overcome through education and discipline. “How to think about market prices” will be a topic I will broadly cover on this blog.


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