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Nasdaq Reads: Gary Smith, "Money Machine" .

Nasdaq Reads is an ongoing book series featuring talks with authors of books on personal finance, entrepreneurship and innovation topics.

Nasdaq Reads: Gary Smith, "Money Machine"

Gary Smith Nasdaq Reads December 2017Gary Smith is the Fletcher Jones Professor of Economics at Pomona College in Claremont, California. He has written (or co-authored) ten books and seventy-five academic papers on finance, sports, and statistical pitfalls. His research has been featured in the New York Times, Wall Street Journal, Forbes, Motley Fool, Newsweek and BusinessWeek. 

He was a guest speaker on CNBC, and a keynote speaker at the Brookings Institution in Washington DC and the Mortgage Finance Industry Summit in New York City. He received his B.A. in Mathematics with Honors from Harvey Mudd College and his Ph.D. in Economics from Yale University.

Below is the MarketInsite interview with Mr. Smith about his latest book, "Money Machine: The Suprisingly Simple Power of Value Investing."


Q:  Your book is about Value Investing and it’s noted that successful investors such as Warren Buffet believe in this premise. Can you provide a simple overview of this concept?

Most investors buy stocks because they hope the price will go up. Buy a stock today for $20 and sell it next week for $30. Unfortunately, it is very hard to predict short-term zigs and zags in stock prices. The price next week might be $30, or it might be $10. No one knows.

Think about it. For every buyer, there is a seller. For every person who buys at $20, thinking the price is about to go up, there is someone selling for $20, thinking the price is about to go down. If it were clear which direction the price is headed, there wouldn’t be a balance between buyers and sellers.

The great thing about value investing is that you don’t need to predict short-term movements in stock prices. As long as the company is profitable, pays good dividends, and the stock was purchased at a reasonable price, you will do fine.

One of Warren Buffett’s aphorisms is, “I buy stock on the assumption that they could close the market for 5 years.” The point is to stop trying to predict short-term price movements and, instead, think of stocks as money machines that generate cash every few months—cash that happens to be called dividends. The key question is how much you would pay to own the machine in order to get the cash. People who think this way are value investors.

Q:  Today the equities markets continue to rise, many think we are in a bubble and others think there is even greater room for the market to grow. As the author of a book that provides information on spotting bubbles, what would you hope that a reader of your book would evaluate today’s market?

We’ve enjoyed an eight-year bull market, and bears warn that we are in bubble territory. Is it time for value investors to bail? Nope.

Remember the dot-com bubble?. Most dot-com companies had no profits. So, wishful investors had to think up new metrics for the so-called New Economy to justify ever higher stock prices. Instead of being obsessed with something as old fashioned as profits, we should look at web-site hits and eye-balls.Things are very different today. There are inevitably some stocks that make you wonder (need I say Tesla?) but, overall, the traditional valuation metrics indicate that this is no bubble. Dividends and earnings are strong and interest rates are low. Investors aren’t inventing fanciful metrics to justify delusions.

I don't know whether stock prices will be higher tomorrow, or next week, or next month than they are today, but I do know that, for a value investor taking the long view, stocks are not expensive.

Q:  It is clear that many markets (e.g., real estate, equities, and even currency valuations) can rise or fall based on purely psychological factors. What are some psychological traps that have tripped up investors throughout history?

We are all susceptible to natural human emotions, not just in the stock market. Our emotions affect our jobs, our romantic relationships, our families. But one of the keys to being a successful investor is controlling our emotions—not chasing rising stock prices because we are greedy, not fleeing falling prices because we are fearful. When stock prices fall, a true value investor does not panic and sell everything. Instead, a value investor thinks, “Wall Street is having a sale” and backs up a truck to fill with bargain-priced stocks. It is difficult, but rewarding. Three other common psychological traps are anchoring, sunk costs, and a break-even mentality.

Anchoring:

Anchoring is a human tendency to rely on a reference point when making decisions. A student did a term paper in one of my statistics classes in which randomly selected students were asked one of these two questions:

The population of Bolivia is 5 million.

Estimate the population of Bulgaria.

The population of Bolivia is 15 million.

Estimate the population of Bulgaria.

Those who were told that Bolivia’s population was 15 million tended to give higher answers than did those told that Bolivia’s population was 5 million. People use a known “fact” as an anchor for their guess.

When we buy a car, we tend to judge whether we are getting a good deal by comparing the final negotiated price to the dealer’s initial price. Thus, a good salesman starts the haggling with a high price.

In the stock market, it is tempting to use the price we paid as an anchor for what a stock is worth.

Sunk Costs:

You buy a colossal ice cream sundae for a special price but, halfway through, you’re feeling sick. Do you finish the sundae because you want to eat what you paid for? The relevant question is not how much you paid, but whether you would be better off eating the rest of the ice cream or throwing it away.

There is nothing to be gained and much to be lost by moping about things you can’t change. Things that can’t be changed are called sunk costs. The ice cream sundae you bought but would get sick finishing is a sunk cost. So is the price you paid for a stock. Yet, many investors are reluctant to sell losers, despite the tax benefit, because selling for a loss is an admission that they made a mistake buying the stock in the first place.

A Break-Even Mentality:

Two students and I studied experienced Texas Hold ’Em poker players and found that most played looser after a big loss (staying in with hands they would normally fold). They evidently remembered their big losses and were eager to win back what they had lost.

Was this riskier play punished? It seems likely that experienced players use sound strategies, and that any changes are a mistake. That’s what happened. Players who played looser after a big loss were less successful than they were with their normal playing style.

If investors are like poker players, they may be tempted to make long-shot investments to recoup losses. A February 2009 article in the Wall Street Journal reported that many investors were responding to their stock market losses by making increasingly risky investments: "the financial equivalent of a ‘Hail Mary pass’—the desperate attempt, far from the goal line and late in a losing game, to fling the football as hard and as high as you can, hoping it will somehow come down for a score and wipe out your deficit."

We should try not to let a break-even mentality lure us into Hail Mary investments.

Q: Any last tid-bits of advice for our readers on smart investing?

It’s all about the cash. Don’t try to predict whether stock prices will be higher or lower a few seconds, minutes, or days from now. Think of a stocks as money machines and think about what you would pay to own such wonderful machines.

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