Empathy, psychology can be a wise investor's best friends

by James K. Glassm

The late Benjamin Graham — erudite classicist, mentor to Warren Buffett, highly successful investor, and probably the greatest financial mind of the 20th century — said it best: "The investor's chief problem — and even his worst enemy — is likely to be himself."

Often our emotions cause us to take stupid, self-destructive actions when it comes to money.

On the other hand, you may be able to profit from this very phenomenon. That's the thrust of an article in the new issue of the Bernstein Journal titled "Exploiting the Effects of Emotions on the Capital Markets." Before getting to the profit part, let's look at the weird world of irrational decision-making, driven by emotion.

Daniel Kahneman of Princeton won the Nobel Prize for his work integrating psychology and economics last December. Kahneman, in conjunction with his late collaborator Amos Tversky, wrote a landmark paper in 1979 that put forward an idea called Prospect Theory. Their point was that, under some circumstances, people aren't rational actors in their economic decision-making; they are influenced heavily by their emotions.

A simple example is that consumers may drive across town to save $5 on a $15 calculator but not to save $5 on a $125 coat — even though the gain is precisely the same.

One of Kahneman's more striking discoveries is that people detest losses. In one experiment, subjects were asked to choose between a gamble that gave them an 80 percent chance of winning $4,000 and one that gave them a 100 percent chance of receiving $3,000. Even though the first choice was mathematically preferable, 80 percent of the subjects chose the certain $3,000.

Then, Kahneman offered a choice between an 80 percent chance of losing $4,000 and a 100 percent chance of losing $3,000. This time, 92 percent of the subjects chose to take the gamble — even though, mathematically, it was the worse selection. Why the change? Because people really, really don't like to lose.

As the article in the journal published by Sanford C. Bernstein & Co., the New York money-management and research firm, says, "Real-world tests reveal that people hate losing money even more than they like making it." The mere chance of a loss is so disturbing that many people would rather make what they believe are riskless investments, rather than making investments which have proven far more profitable with only slightly more risk over the years.

What does this mean in real life? Well, many people in their thirties and forties direct part of their 401(k) retirement contributions to money-market funds, a foolish choice. Also, "through mid-2003," says the Bernstein Journal article, "investors were still pouring more money into bond funds than stock funds, even though interest rates had fallen to less than nothing after inflation and taxes while the stock market was finally showing signs of life. . . .

"With the taste of stock-market losses still sharp on their tongues, investors ignored the facts. They kept rushing into bonds, thereby almost assuring themselves little or no reward. Meanwhile, stocks rose and fell and rose again, as is their wont, and ended the first half of 2003 with healthy gains."

Probably the most intriguing — and productive — of the Kahneman-Tversky quirks is called "anchoring." People tend to anchor their predictions in the present; that is, they use prevailing conditions as their base and are reluctant to believe that the future will be much different.

For example, what would you say to an economist who predicted that inflation would average 5 percent over the next ten years? You would probably have serious doubts because inflation has been just 2 percent lately. But over the past forty years, inflation has indeed averaged 5 percent, and "there's no reason it couldn't return to that level," notes the Bernstein Journal article.

Stock analysts are especially prone to the effects of anchoring. "Research," says the article, "has proved that, when faced with a major change ahead for a company, analysts will generally make a series of small earnings-estimate revisions, each of them inadequate to reflect what's really going on." Sanford Bernstein's own money managers exploit this tendency by delaying the purchase of an attractive stock whose earnings have been downgraded — "because subsequent downward revisions are likely and will probably further depress the price."

What about companies whose earnings are rising? Back in February 1999, I wrote about an investment firm that developed mutual funds to take advantage of anchoring in just this way. The firm, Fuller & Thaler Asset Management, is run by Russell Fuller, the hands-on manager, and Richard Thaler, a well-known expert in behavioral (that is, Kahneman-Tversky-style) economics at the University of Chicago.

Fuller and Thaler look for stocks with big jumps in earnings. They then check to be sure the earnings spike isn't a one-time-only event and that the company is sound. Next, they look for analysts who underreact to the change. "Say that the company reports earnings that go from $1 to $1.80," Fuller told me in an interview in his office in San Mateo, Calif. If he is an anchored analyst, he says, "I am so overconfident that I give no weight to this new information in my next forecast. My first reaction is to reject it."

The analyst will eventually start raising his forecast, but since he's still anchored at $1, he'll go to $1.40 rather than $1.80 or $2. Finally, the analysts catch up to reality. Meanwhile, Fuller and Thaler buy the stock at a relatively low price and ride it up.

To begin, Fuller and Thaler search, especially, for small- and mid-cap companies, where the judgment of only a few analysts can have a big effect on prices. One of Fuller's favorite examples, when he was just putting the theory to work, was office-furniture maker Herman Miller (MLHR), which registered 10 consecutive earnings "surprises" after an initial jump in 1993 that analysts wouldn't believe. The stock sextupled.

The Fuller-Thaler team has managed two funds for the Undiscovered Managers group in Dallas. The Behavioral Growth fund (UBRRX) has returned 57 percent so far this year and an annual average of 10.3 percent for the five years ended Sept. 30, compared with just 1 percent for the benchmark Standard & Poor's 500-stock index. The Behavioral Value fund (UBVLX) is up 37 percent in 2003 and, launched later, has produced average annual returns of 12 percent since October 2000, clobbering the S&P.

Top holdings for Behavioral Growth include SanDisk (SNDK), which makes flash-memory storage cards for cameras, music players and the like; Gen-Probe (GPRO), maker of screening tests for HIV and other infectious diseases; and Coach (COH), leather accessories.

In the end, the best way to exploit the emotions of other investors is to keep your own wits about you. Remember that nothing goes up — or down — forever, that a little bit of risk is usually worth taking, that turnarounds can be for real, and that the best deals today are often the ones that other people are shunning.