Inside versus Outside View

The Brooklyn Investor has a thought provoking post on reading too much into market valuations that are high, but not obscenely so.

I’m referring to the fallacy of assuming that since all bank-robbers had guns, that all gun-owners must be bank robbers.

We all look at these long term valuation charts and go, hey look!,  the market P/E was over 20x before 1929, 1987 and 1999! So, the thinking goes, the market is now over 20x P/E so a crash must be imminent! But then we tend not to look at all the people who own guns that are not bank robbers.

Also, when someone says that the stock market is 90% percentile to the expensive side, there is a tendency to want to believe that there is a 90% chance that the market will go down in the future. Well, if the market is 90% percentile to the expensive side over the past 100 years, then it means that the market will be valued at a lower level 90% of the time in the next 100 years if the same conditions occur.

Poring through historical data, he finds something “counter-intuitive”. Expensive valuations are often characterized by positive 1-year prospective returns.

As I was reading the blog, I was reminded of Kahneman’s inside versus outside view, which I first learned through Michael Mauboussin’s discussion of Triple Crown winners. Here is a PDF link, which discusses some of the same issues.

 

 

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