Brain damage can create superior investment results, at least according to James O’Shaughnessy in his classic What Works on Wall Street .
O’Shaughnessy refers to a study by Baba Shiv of Stanford University that found that people who had suffered damage to the amygdala or the insula regions of their brains made better investment decisions and had higher returns than those with normal, healthy brains (see the 2005 Wall Street Journal article on the same study).
As it would turn out, those two brain regions happen to control how we perceive risk. Shiv found that his healthy test subjects allowed their prior losses to cloud their judgment, causing them to be excessively risk averse. The brain-damaged investors had no such inhibitions and approached each new investment opportunity without being rattled by prior losses.
So, what conclusions are we to reach from this? Were successful contrarian investors like Warren Buffett dropped on their heads as babies? Should we lobotomize all money managers to improve their performance?
Ah, if it were only that simple. As O’Shaughnessy writes, “our brains are wired the way they are for very good reasons… Indeed brain damaged patients like those in Shiv’s study often went bankrupt because a lack of emotional judgment made them too risk-seeking and susceptible to scams.”
Science has not yet created a switch to flip that will turn us into perfectly rational investors. Alas, the burden of emotional control lies with us. When you feel your heart racing, either in euphoric anticipation of profit or paralyzing fear of loss, you have to step back and consider the numbers dispassionately.
With all of this said, what are investors to make of today’s market? Yes, the market has had a nice run of late, and the S&P 500 is close to hitting its old high. Yet equity mutual funds bled over $19 billion in redemptions in August, the last month for which data is available. This was the sixth month in a row in which investors pulled their money out, and the fourteenth month out of the last 16 (see IBD’s “Mutual Fund Outflow Soared in August“).
Meanwhile, bond funds have seen net inflows for the past 12 consecutive months. Yes, the same bond funds that are buying 10-year Treasurys at 1.6% yields — well below the rate of inflation.
After the 2008 meltdown, the 2010 Flash Crash, and the past two years of “on again / off again” sovereign debt crisis in Europe, investors have dug themselves into a bunker. Having been burned, they are reluctant to touch that hot stove we know as the stock market again.
For those of us willing to look at the numbers — or perhaps those of us suffering from brain damage — there is ample upside left in this market. At approximately 14 times earnings, stocks (as measured by the S&P 500) can hardly be considered expensive. And when compared to bonds yielding significantly less than the rate of inflation, stocks would appear outright cheap. With prices reasonable and individual investors having already largely fled equities, it’s hard to see the conditions for a sustained bear market.
But even if macro concerns of excessive investor pessimism keep a lid on stock prices in the months ahead, dividend paying stocks offer respectable cash payouts that appear close to as safe as bond yields. According to Standard & Poor’s, the stocks of the S&P 500 currently pay out only 30% of their earnings as dividends. It is difficult to see widespread dividend cuts coming from such low levels.
At current prices, I believe a portfolio of dividend-paying stocks, REITs, and MLPs with high and rising cash payouts is the most sensible option for most investors. But then, there might be something wrong with my amygdala.