Irrational Pastime
When some investors march out to do battle with the markets, logic seems to go AWOL. People hoard their losers and dump their winners. They trade a dull nickel for four shiny pennies. Hoping to recoup a loss, they double up on risk and turn a modest defeat into a bloody rout.
There are a million ways to lose money, and some investors seem to be methodically working their way down the list. Consider the man in rural Harvard, Mass., who once had a fortune in the stock of Digital Equipment Corp., based in nearby Maynard.
When financial planner Dee Lee saw him in church recently and mentioned Digital, “his face went blank,” she said.
Yes, he’s still holding the stock; it just isn’t worth a fortune anymore. As the crash of 1987 toppled Digital from its all-time high of $197.75, he held. As it slid to $100 in 1989, to $50 in 1992, to $19 in 1994, he held.
In early 1996, Digital briefly rallied above $70 but has never come close to that since. During the ‘90s, in fact, the stock has averaged in the mid-$40s, right where it is today.
“You can tell people about the opportunity cost of holding on to a bad stock, the money they’re losing by not investing in something else,” Lee said. “Sometimes they just won’t sell.”
The prevailing wisdom among economists is that markets are efficient and rational--they reflect the collective activity of investors who instantly soak up all the available information and focus unswervingly on maximizing their gains.
But how do you account for irrational investors?
“I don’t call them irrational,” said Meir Statman, a finance professor at Santa Clara University. “I call them normal. You can never confuse a rational person; such a person is nonexistent.”
Statman is one of a number of researchers tilling a relatively new academic field known as behavioral finance. Their aim is to identify and explain investor behavior that doesn’t fit the rational model.
Critics think it’s a fruitless effort.
Economist Merton H. Miller, a Nobel laureate from the University of Chicago, has little use for behavioral finance because to him it describes only what the losers are doing.
Because every transaction also has a winner, the net effect is a wash, Miller said in a recent interview.
“Unless it has an effect on the overall level of prices, it doesn’t matter,” he said.
Statman counters that some investor errors--overtrading, for example--lead to real waste.
“Suppose I jump in and out of stocks,” he said. “It’s true that I may be getting a fair price for any particular transaction, but I am wasting a lot of my time and money in commissions. For the economy as a whole, it’s a dead-weight loss. It’s the equivalent of loading and unloading a truck.”
Moreover, apart from whatever effect it may have on the overall economy, knowing a bit about your own psychology may help keep you from making some elementary mistakes.
Statman believes that two of the most powerful forces driving investors are pride and regret.
The Digital investor can’t bring himself to sell because that would mean finally owning up to a loss and exposing himself to the agony of regret. As long as he holds on, he can nourish the dream that Digital will one day recover its competitive position and get him back to even on his investment.
Statman had a piece of advice for the man’s advisor: “If she’s really crafty, she could tell him: ‘Sell it. If it goes wrong, you can blame me.’ ”
Financial planners and full-service brokers won’t like to hear it, but Statman thinks that one of their most important functions is to serve as scapegoats for their clients.
If their advice results in a profit, they shouldn’t expect any praise, and if it results in a loss, they should expect to shoulder full blame. Only in that way can the client enjoy the pride of successful investments and be shielded from most of the regret for the ones that don’t work out.
“It’s never stupid me,” said Statman, “it’s my stupid advisor.”
Another common way investors shield themselves from regret is by buying the stock of “good” companies, the ones that always show up in Fortune’s annual survey of firms most admired by corporate executives.
Everybody knows that Coca-Cola Co. is a terrific company, the reasoning goes, so how can I possibly be faulted for buying Coke stock? If my stock in some obscure small company falls, that’s my dumb investment, but if Coke falls, why, that’s an act of God!
The fallacy, of course, is that good companies aren’t always good investments. As Coca-Cola investors found out this summer when the stock--trading at more than 40 times expected earnings--finally tumbled, the stock of a good company can also be overpriced.
Although failing to act when action is necessary--taking a loss, for example--can be a problem, there are plenty of occasions when sitting still is the best policy.
A much-publicized study by Terry Odean, a finance professor at UC Davis, shows the stocks sold by discount brokerage customers--presumably acting without professional advice--outperformed the ones they bought. His conclusion is that investors are overconfident about how much they know.
A corollary, according to Statman, is that investors often load up on “hometown” stocks or stocks of their employers, figuring that because they know those companies better, they have an advantage. But with Wall Street analysts meeting frequently with management and with company insiders buying and selling the stock, chances are slim that an outside investor--even one who lives next door--will know more than the rest of the market.
“Investors should ask themselves when they’re buying a stock, ‘Who’s the idiot who’s selling?’ ” Statman said.
Another human failing is the lack of self-control, but Statman said investors are generally aware of that one. They’re so aware, in fact, that they sometimes cause themselves problems by overcompensating.
The classic mistake is to have far too much of one’s salary withheld for taxes so as to create a kind of “forced savings” in the form of next spring’s refund. The problem is that you are throwing away the income you could earn on that money by investing it this year.
Far better, in Statman’s view, are strategies that cope with the self-control problem by creating “mental accounts.” If you label a particular savings account “Suzy’s college fund,” you’re much less likely to dip into it for a new set of golf clubs.
One reason some investors love stocks that pay dividends, according to Statman, is that they feel much less guilty about spending a dividend check than they would about selling a few shares of stock for the same purpose.
The federal government addresses investors’ lack of self-control by imposing stiff penalties on early withdrawals from individual retirement accounts, 401(k)s and other retirement savings plans. (And sometimes Congress acknowledges its own lack of self-control, adopting spending caps and other budgetary restrictions.)
Many Wall Street observers have noted a herd instinct among investors. Contrarians have turned this observation into an investment strategy, trying to do the opposite of what the herd seems to be doing.
If some people always sell at the bottom and buy at the top, one reason may be what academics call the representativeness fallacy--the belief that a past pattern will inevitably carry into the future.
When New York financial consultant Peter L. Bernstein was a money manager years ago, he got a new customer, an entrepreneur who had made a fortune taking his company public.
“Look here, young man,” the client said, wagging a finger in Bernstein’s face, “you don’t have to make me rich. I am rich.”
Accordingly then, Bernstein recalled in a recent interview, he was cautious with the man’s money, putting only a third of it into stocks. Thus the client missed the brunt of a sharp downturn, losing only 10%, while some aggressive investors had half their portfolios wiped out.
But Bernstein arrived at the office one morning and was stunned to find the man waiting there in a state of hysteria.
Having watched his stocks sink steadily for months, the client--though a sophisticated businessman--could only imagine their falling further. It was no comfort that gains in the rest of the portfolio helped balance out the stock losses.
“Over our kicking and screaming, he sold out!” Bernstein exclaimed. When the inevitable rebound came, he was out of the market.
Bernstein’s client “was inferring too much from too little evidence,” Statman surmised. “Having got his first taste of stocks, he said: ‘I’ve figured it out: Stocks are losers.’ ”
The same mistake is made by those who judge a mutual fund by last year’s performance, or even by the last five years’, Statman said.
“There is a great herd instinct in our business,” said Joan Payden of Payden & Rygel in Los Angeles. “In ‘81-82,” the 30-year U.S. Treasury bond “was yielding 13%, but I couldn’t get anybody to buy it. ‘Why buy now?’ they’d ask. ‘It’s going to 20%.’ ”
The University of Chicago’s Miller states flatly that stock investors ought to be in index funds because there is virtually no hope of beating the broad market over time.
Statman, more indulgent of human emotions, said one of the main reasons people like to pick stocks or mutual funds is that it’s fun. “The stock market is the biggest entertainment on Earth,” he said.
To prescribe a strict diet of index funds is to deny people their enjoyment, he said.
“Miller wants to take the steak and the potatoes, grind them up together and serve you the mush. ‘Don’t you understand?’ he’ll say, ‘It all ends up the same in your stomach!’ ” said Statman. “But what if I like my potatoes separately?”
If you make investing “emotionally boring,” Statman said, some people won’t invest at all--which is worse for their financial health than investing imperfectly.
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SPECIAL MUTUAL FUND PACKAGE
Today’s Wall Street, California pages include several valuable tools to evaluate your investment portfolio, including:
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-- How to get financial ideas from the Internet. D5
-- An interview with professional fund-picker Kurt Brouwer. D4
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Logic and Emotion
Some of the things investors do fly in the face of logic. But investing is an emotional activity, and there’s no way to banish pride, fear, impatience and regret. Researchers into investor behavior say that one way to keep your passions in check is to be aware of their influence. A few guidelines:
* Do recognize the natural tendency to try to “get even.” Therefore, Don’t tie up your money by refusing to sell a losing investment, especially if there are tax benefits in accepting the loss.
* Do use mental tricks to force yourself to save if you feel you lack self-control. Don’t overlook the downside of such schemes. For example, over-withholding on your taxes in order to get a bigger refund means giving Uncle Sam money for a time that should be yours to invest.
* Don’t think you can beat the market. Overconfident investors tend to trade too much, hurting their performance in the long run.
* Don’t assume that a one-year or even a five-year track record for a mutual fund or a stock is enough evidence to indicate where the investment is headed next year.
* Don’t equate “good” companies--those that show up on most-admired lists, for example--with good stocks. Popularity boosts prices, so an ugly duckling may be a better value than a swan.
