Sunday, May 28, 2006

David Dreman and the Long View

SmartMoney's Beverly Goodman interviews David Dreman.

You began your work in behavioral finance with the study of heuristics — essentially, rules of thumb. How does that influence the way people invest?

Heuristics are simple guidelines that we use without thinking. We need them to operate, and they work very well most of the time. For instance, if you're driving down a city street, you focus on what you should see — like other cars, traffic lights, etc.-and ignore everything else, like all the people on the sidewalk and things going on in nearby apartments. Heuristics allow people to concentrate on what's important at that moment. A shortcut, in a sense.

So where do they go wrong?

Heuristics don't work when people aren't good statistical processors. There's been a lot of research on cognitive heuristical errors, such as how people focus on the case rate rather than the base rate of whatever statistics they're evaluating.

Base rate and case rate?

The base rate is the long view. Sharks attack something like one in 5 million swimmers — that's the base rate — but that doesn't stop people from avoiding the water after a highly publicized shark attack or seeing Jaws — the case rate.

How does that apply to the stock market?

With stocks, the base rate is the 10% the stock market has returned on average over decades. The case rate is what the market's been doing for a few weeks or months or even a couple of years. So when we get a bubble, like what we had in the late 1990s, people immediately go over to the case rate — the short-term return — and project that into the future forever. So they end up paying too much for their stocks.

[see also Philip Durell's interview]

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