The economy and human nature

Dr. Andrew Turner – managing director of investment management & research for the Russell Investment Group – predicted modest gains for the stock market this year and elaborated on what he called “behavioral finance.”

Turner addressed the Lakewood Chamber of Commerce Thursday at the Tacoma Golf & Country Club, site of this month’s general membership luncheon.

Stock market investors should expect single digit returns this year, he said, adding he doesn’t expect the stock market to have the double digit growth of 2003.

Turner’s assessment of the market was based largely on the low interest rates of treasury bonds. Rising rates, he said, are usually indicative of lower market growth.

“Interest rates are now at the level they were in the 1960s,” he said, explaining current rates are hovering at just over 4 percent. “Treasury bonds have uniformally declined.”

With rates unable to fall much lower, he said they are likely to go up a point or two in the next 18 to 24 months.

“If they rise, that does not bode well for the stock market,” he stated.

Offering a more long term prediction, Turner said he expects rates to go up over the next 2 to 5 years.

“Now, what does that say about what is happening in the economy?” he asked.

While low rates are causing a deflationary environment in Japan, Turner said there is virtually no chance of that happening in the United States.

Market volatility has been high, he said, although not high by historic standards. Cross sectional volatility – the difference between individual stocks and the market as a whole – has been high by historic standards, he pointed out. That means there is the possibility of big gains or big losses when it comes to investing.

The trend of the U.S. dollar declining against other international currencies will continue, he noted.

“That won’t reverse in the near term,” he said, “but the U.S. economy is strong.”

The cyclical movement of the market is the reason Turner advised diversified holdings, because it’s difficult – even for experts like himself – to predict when things are going to change.

How investors respond the the ever-changing market brought him to what he calls “behavioral finance,” a term that refers to how people make decisions about money matters and what influences them.

He highlighted four main factors: framing, anchoring, overconfidence and extreme risk-aversion.

– Framing is a model imposed on a problem in an attempt to figure it out.
“Human beings tend to frame things too narrowly,” Turner said, illustrating his point by having the audience look out only one pane of a much larger panel of windows. Such a constricted view prevents people from seeing the wider world.

Instead, what people should do is try to think of a problem in bigger terms, he said.

“The key to solving problems is going outside the box,” he said.

Turner then referenced the well-known challenge where one is asked to draw four straight lines through the middle of all nine dots arranged in a set of three rows without taking your pen or pencil off the paper. (Go ahead and try it. You know you want to.)

– Anchoring is the tendency for people to base their beliefs on what they just heard or what just happened.

After telling the audience the Verrazano-Narrows Bridge in New York City has a total length of 13,700 feet, he then asked the audience to estimate the total length of the Tacoma Narrows Bridge.

Although most in the audience were well-informed and approximated the correct answer (over 5,900 feet), Turner said most people usually guess much higher based on the information he provided about the Verrazano-Narrows Bridge.

– “It’s very unusual to find someone who is – shall we say – well-calibrated,” Turner said in reference to overconfidence.

By that he meant people who not only know what they know, but are also aware of what they do not know. In other words, those who don’t claim to know it all.

“People are overconfident on everything,” he said.

– At the other end of the spectrum is extreme risk-aversion.
“People often make the mistake of evaluating on a stand-alone basis,” he said, “on what is likely not the last gamble of your life.

“They don’t take risks that are okay.”

When it comes to business and investing, Turner recommended keeping these four factors in mind when making important decisions.

While he tries to take his own advice, Turner admitted that he’s only human and sometimes has difficulty following his own counsel. He must be doing well, however, considering his lofty position with the Russell Investment Group.