Ernest R. House Archives: 2022

2011

Decision Making via Evaluation: What’s Marv’s Opinion Worth?

Ernest R. House

(For the Symposium in Honor of Marvin C. Alkin, Issues in Evaluation and Decision Making in Society, UCLA, Los Angeles, CA, June 3, 2011)

When I first thought about this presentation, I listed several of Marv’s qualities that I thought were exemplary. These included sound judgment, generating innovative ideas, developing some key concepts, and employing clever teaching methods. Today I am limiting myself to discussing Marv’s judgment. I know what you’re thinking, “Yeah, yeah. Everyone has sound judgment. Talk is cheap.“ Indeed, talk is cheap. What’s Marv’s opinion really worth? Let me see if I can put a number on it.

Each year at the American Evaluation Association meeting, Marv and I get together to talk about evaluation and investing. Both of us are interested, active financial investors. My interest started about 1993 when I first considered semi-retirement, following several hours of a faculty meeting in which colleagues lamented how important their work was and how they were never given enough recognition. For the first time in my life, I thought maybe I needed to get serious about my retirement investments.

In 2007 the AEA conference was in Baltimore. It was cold, and Marv and I had lunch at some cheap restaurant around the corner from the conference hotel. Among other topics, I told him about my investment in Berkshire Hathaway, Warren Buffet’s company. At the time the stock was worth about $4400 a share ( around 11/ 2/07), and I had something like 180 shares. Marv said, “I would love to own some Berkshire myself, but you have too much money invested in it. You really should reduce your holdings.” He reiterated this advice as we left. It’s a maxim among investors that they should diversify their holdings and not put too much in any one investment. You never know what might happen.

Now I knew this as well as anyone, but I had become enamored of the company. I had made a lot of money in the stock, and even though I anticipated a downturn in the stock market the following year (which turned out to be the great financial meltdown of 2008, and much worse than I thought), I had confidence that this stock could withstand a decline without losing much value. After all, this was Warren Buffet, the greatest investor of our time, running one of the most successful companies of the past fifty years loaded with cash. If the market did decline, Buffet had all this money to take advantage. Berkshire certainly constituted a large part of my investment portfolio, and I was putting a lot at risk in one basket.

Investment is a lot like evaluation. In fact, I would say it entails a form of evaluation in which you collect information, make judgments, and have results rocketing back around your head in short order. Investing is also highly emotional. Indeed, Buffet says successful investing requires an IQ of only 120. Any points beyond that are wasted. On the other hand, controlling your emotions is critically important and sometimes quite difficult. After the conference, I flew back to Colorado thinking about what Marv said. After a few days, I decided to cut back significantly on my investment in the stock. I kept some of it.

The 2008 financial meltdown was more extreme than anything since 1932--courtesy of America’s investment bankers, who evidently are unable to surmount the 120 IQ point threshold. Berkshire stock dropped from a high of $5000 to a low of about $2300. If I had held onto my original investment, I would really have taken a bath. What happens is that in a severe decline even seasoned investors have a strong inclination to panic, and the more they have in an investment the more likely the panic as they see their net worth plunge. Without reducing my position significantly, I would have been having horrendous nightmares imagining endless faculty meetings discussing parking spaces. Today the stock is the equivalent of $4000 (after a 50 for 1 split). It’s still not back to where it was when Marv and I talked.

The interesting thing about this episode is that Marv provided no information that I didn’t know. I knew the maxims about diversification of assets. What precipitated my action was his balanced judgment that I should reduce my holdings. Might I have acted similarly for other reasons later on? Maybe, but it’s a fact that I did it based in our interaction that day. I calculate Marv’s opinion is worth someplace between $380,000, if I had sold out at the bottom of the plunge, and $72,000 if I had held on to the entire lot until now, give or take a hundred thousand if I had done something in between. This is an example of decision-making based on an evaluation in which the credibility of the information source was the determining factor that impelled me to change my position.

What makes Marv’s judgment sound? First, he is knowledgeable and well informed about investing. Second, he considers all the angles carefully. Third, he is not too excitable, at least in this area. He’s not an alarmist. And, fourth, he is not overwhelmed with his own self-interest. This last characteristic is important because a signal danger of investment advice is that the advice is often given to enhance the interests of the adviser not the person receiving the advice. Advisors frequently have conflicts of interest in which they profit somehow from the advice they give. I believe this advice was given with my interest in mind. This factor is important in assessing the source’s credibility and is based on a holistic judgment about the source.

Three other features of this decision-making via evaluation process are worth noting. The situation was interpersonal. In other words the evaluation process was conditioned by the interaction of two people, even though I was the one who made a decision. Second, the process was also communal. It wasn’t merely two people acting on their own. These two people were members of a larger community, the investment community, and were considering maxims of wisdom generated by that community. Marv and I didn’t originate the caveat about diversification of assets. We knew this from reading and learning the common wisdom of the community. By the way, diversifying holdings doesn’t always work well. No maxim ever does. There is always the question of when and where to apply it.

Of course, investment decisions can be taken based on other types of evaluative information altogether. In 2000 I was a fellow at the Center for Advanced Study in the Behavioral Sciences at Stanford, and Alan Krueger, an economist, told me one of his colleagues, Robert Shiller, had just published a book called Irrational Exuberance. This was at the height of the dot-com boom in which stocks, particularly tech stocks, had skyrocketed. During 1999, the previous year, I had twenty mutual funds that averaged a return of fifty percent for the year. In my life things that good just don’t happen. I had become increasingly nervous about the stock market and rushed all over Menlo Park trying to find a copy of the book. I found one and read the book immediately on a Sunday afternoon. What impressed me most was a graph tracking the price-earnings ratios of American stocks over the past hundred years. At the beginning of the dot-com boom, the trend line suddenly took off like a rocket, shooting up at a steep angle. Nothing like this had occurred in a hundred years. Investors call this a parabolic move, a sign of danger since such moves don’t last long. The other side of the parabola is the plunge. The normal P/E ratio was about 16, and this one was around 35. Commentators on television were heralding the beginning of a new age. But for me, the stark graph was the clincher. In my experience, life giveth, and life taketh away.

Next day I began selling all my stocks. This happened to be the very day the stock market broke for the first time in the big dot-com bust. The graph saved me a lot of grief. I kept ten percent of my stock investments and lost the same percentage on that portion as everyone else, about thirty percent. However, this was thirty percent of ten percent, not of one hundred percent. Again this evaluation judgment was interpersonal, through interacting with one person I trusted, and another whose reputation I knew, both outstanding economists. And, again, knowing the price/earnings ratio alone is not enough. You have to know what it meant in the context of Shiller’s analysis of behavioral economics.

One final point. The validity of these evaluations is domain specific. Marv’s opinion is good within a particular domain. I don’t believe I ever asked his opinion about basketball. He might not be as impartial or unexcitable. Domain specificity is important. To illustrate this point, staying with the investment example, one strategy for investing success is to find a small number of people--let’s call them financial evaluators-- who are able to make outstanding judgments and to be guided by these people. Warren Buffet is one example. Buffet is widely regarded as the most successful investor of the post-WWII period. He built Berkshire into a great company by his ability to judge the value of other companies as investments. During this post-war period, the US economy was expanding and dominating the world in manufacturing.

Of course, all that is changing. Manufacturing has shifted overseas to the emerging markets, particularly China, which is already the dominant manufacturing power and will soon be the largest economy. In the past several years Buffet has struggled to find investment opportunities. It’s not the same world in which he learned his trade and acquired his investment wisdom. During the 2008 financial meltdown, he did all right. He made some good investments, but nothing like he might have done with the amount of cash he was holding. He later said about himself during the crisis period, I did not cover myself with glory. He’s still a good investor, but perhaps not the great one he was in earlier times. The world has shifted on him. Lee Cronbach (1982) once said that a major problem of research findings in the social sciences is that generalizations seem to hold for a while and then are valid no more. “Generalizations decay.” Unfortunately, as the world changes, it is possible for even the wisdom of great evaluators to decay as well. Fortunately, we don’t have to worry about this with the astutely engaged Professor Alkin.

References

Cronbach, L. J. (1982). Designing evaluations of educational and social programs. Jossey-Bass: San Francisco.

Shiller, R. (2000). Irrational exuberance. Princeton, N. J.: Princeton University Press.