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.
|