For Investors, Inertia May Be a Costly Force

One law of physics doubles as a standard rule of personal finance: Inertia is a strong force.

The inclination, or outright desire, to leave one’s investment portfolio as it is usually trumps any urges to make change. In other words, what you have, you’re likely to keep, for better or worse.

Sometimes it is all for the best. Warren Buffett, who knows a thing or two about generating and keeping wealth, has said the best time to sell a stock is “never.” The idea is that it’s smarter to bet on companies growing and prospering in the long run than to trade in and out of them, trying to catch short-term peaks and valleys in stock prices while incurring trading costs and taxes.

But last week brought more reminders that never selling also can be hazardous to a portfolio.

On Thursday, one of the greatest American technology brands of the post-World War II era--Polaroid Corp.--proposed ending its bankruptcy proceedings by selling its remaining assets to an investor group for $265 million.

The deal, if approved by the Bankruptcy Court, would mean that one of the so-called Nifty Fifty blue-chip issues of the early 1970s would be a total loss to shareholders. As recently as 1997, Polaroid still was a $60 stock. On Friday it was trading for a nickel.

Also last week, major telecom-company shares initially rallied from what had been multiyear lows, only to fall back into a tailspin Thursday and Friday--leaving battered telecom investors to ask once more, “Where’s the bottom?”

Lucent Technologies, which hit a record low of $3.80 on Monday, shot up to $4.60 by Wednesday, a 21% gain from the low. By Friday the stock was back to $4.29.

WorldCom Group, which hit a 10-year low of $4.77 on April 11, rallied to $6.51 by Wednesday, but by Friday was at $5.98 at the end of regular trading on Nasdaq. Late in the day, the No. 2 long-distance company cut its forecasts for 2002 sales and revenue, sending the stock price down to $5 in after-hours trading.

Since telecom and technology stocks peaked in 1999 and 2000, many investors have held on because they believed, and perhaps still believe, that the sectors are bound to come back eventually. All the way down in these stocks--from Lucent’s record high of $77 and WorldCom’s peak of $61--some investors who’ve stayed put have taken comfort in the idea that they’re in for the long haul, which has a certain noble sound to it.

The lower the stocks have gotten, some investors also have used the argument that “there’s no point in selling now, because I’ve already lost so much. How much worse can it get?”

The answer is that you can lose every dime in some stocks, as Polaroid seems intent on demonstrating. Sometimes, what’s down doesn’t come back, ever.

Of course, someone who bought Lucent at, say, $50 a share in 2000 might not care all that much about the remaining $4.29 a share they have to lose, should Lucent go the way of Polaroid.

But there’s a psychological cost in holding onto stocks that already have lost the bulk of your capital. They can become huge distractions within a portfolio. The time you spend worrying about whether and when the stock will rebound can keep you from focusing on other (better) investment ideas and decisions.

Finance professor Hersh Shefrin, in his book “Beyond Greed and Fear” (Harvard Business School Press, 2000), writes about the psychology of investing and how people typically react to financial challenges.

Most people, Shefrin writes, face “loss aversion”--that is, “they have great difficulty coming to terms with losses.” One result, he writes, is that “people are predisposed to hold their losers too long.”

Shefrin quotes from a brokers’ manual written in 1982 by Leroy Gross: “Many clients ... will not sell anything at a loss. They don’t want to give up the hope of making money on a particular investment, or perhaps they want to get even before they get out. The ‘get-evenitis’ disease has probably wrought more destruction on investment portfolios than anything else.”

If you paid $50 for Lucent, the stock would have to appreciate more than tenfold from its current price to get you back to break-even. Even if that is possible, a key question is how long would it take. Five years? Ten years? Could your money, and time, be better spent in that period?

Even when stocks like Lucent don’t go to zero, history shows that collapses on the scale of those experienced in tech and telecom often lead to long periods when the shares are simply dead money. The companies may recover, but many investors remain suspicious, and reluctant to bid aggressively for the stocks. Besides, more exciting business concepts may be beckoning.

What vexes individual investors perhaps more now than ever is the feeling of not knowing who to believe about technology and telecom stocks.

The opinions of Wall Street analysts have been discredited over the last year as the inherent conflicts of interest within big brokerages have been illuminated: Is an analyst being honest in a stock recommendation, or is the tout aimed at securing investment banking business from the subject company?

Professional money managers who own the stocks have opinions, but they, too, have an ax to grind in recommending them.

As for executives of tech and telecom companies, in many cases they have been as surprised, or more surprised, than Wall Street by the plunge in demand for tech goods and services. Last week, cell-phone giant Nokia Corp. cut its forecast for phone sales this year. That pattern seemed all too familiar to Nokia investors: The firm repeatedly had to cut its sales estimates in 2001.

If the “experts” have few good clues when the tech and telecom sectors will recover, and how substantial the recovery may be, small investors may feel that they’re completely in the dark about what to do with the stocks.

On the other hand, that also levels the playing field: Your guess is as good as anyone else’s.

Faced with that reality, many investors with steep losses in tech or telecom shares may continue to choose inertia as a response (or, rather, choose not to overcome the inertia that is the norm in portfolio management).

But if the paper losses on your stocks consume the time you spend focusing on your portfolio, try to imagine yourself unburdened by those losses and able to concentrate on new opportunities.

There is no guarantee that you will avoid selling your losers at their precise low point. But neither is there any guarantee that by holding on you will recoup much of what you’ve lost so far.

Rethinking the response to natural portfolio inertia applies to more than just investors who’ve suffered major paper losses. Despite the prospects for an economic recovery, the backdrop for stock prices is far different from what it was in the bull-market years of the late-1990s.

Then, peace was breaking out all over, energy prices were down sharply and the federal government was projecting budget surpluses into perpetuity.

All of those trends now have reversed, in varying degrees. They may not make or break individual stock prices, but the way they’re going they aren’t confidence-builders for the market overall.

At the very least, investors who haven’t changed much in their portfolios over the last two years should be asking more “What if?” questions about the economy and the markets, and how their portfolios might fare depending on how those questions are answered.

For those who have built a diversified collection of investments (U.S. and foreign stocks, Treasury and corporate bonds, cash, and hard assets such as real estate or gold), a portfolio review might show that little or no action is required--i.e., inertia is fine.

But investors who have thought about diversification only as an interesting concept may well find that inertia now has become a very dangerous force.

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Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, go to: www.latimes.com/petruno.