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CHAPTER TWO
FAITH IN OURSELVES
THE IRRATIONAL BEHAVIOR OF INVESTORS

THE BEHAVIOR OF INDIVIDUAL INVESTORS

DO PEOPLE ACT rationally when making decisions about their investments? The connection between money and motive can leave us wide open and vulnerable to some very questionable investment strategies. Most economic and financial theory is based on the premise that people do act logically and consider all available information in the decision-making process. However, a surprising amount of evidence exists indicating that human beings show repeated patterns of inconsistency, irrationality, and incompetence when faced with decisions or choices that deal with uncertainty.

For example, psychologists say the technology stock bubble that peaked in early 2000 was due to irrational overconfidence in these companies. Perceived as exciting and ripe for growth, 28these stocks generated investor pleasure as well as pride in their ownership. This was the hidden hook that lured and caught many little fish investors.

The investment industry asserted that technology stocks were benefiting from a factor known as momentum investing, a practice in which investors pile into a stock or sector simply because it is going up. Although the Wall Street explanation sounds more scientific, it acknowledges the herd mentality that occurs with investors because of psychological and social factors.

A relatively new field in psychology known as behavioral finance attempts to explain and better understand the psyche of the investor and how emotions influence the decision-making process.

One of the pioneers of behavioral finance was the late Amos Tversky, professor of psychology at Stanford University. Tversky found that individuals are much more distressed by prospective losses than they are happy with equivalent gains. Faced with a sure gain, many investors become risk averse, but faced with sure loss, investors become risk takers. Mind-forged handcuffs bind us to our mistakes. Some economists have concluded that investors typically consider the loss of one dollar twice as painful as the pleasure from a one dollar gain.¹ Most people are unwilling to realize their losses, and they assume additional risk in an attempt to avoid such losses. This often results in further damage to the investment portfolio.

I’ve found that investors hesitate to liquidate investments that have gone down in value, even when there is a logical, rational argument for selling. Perhaps it is the pain that Tversky refers to when a loss is actually realized. I’ve also seen the opposite occur when an investment has been such a good performer that investors won’t consider selling. Perhaps they fear the possibility of missing out on further gains. They forget that a gain is not a gain until it is realized. This mentality is so strong in some investors that they become paralyzed, unable to make any rational decisions concerning their29 investments. Meir Statman, professor of behavioral finance at Santa Clara University, calls this phenomenon the “fear of regret.”

Regret is the pain we feel when we find, too late, that other choices would have led to better outcomes. It is the ache of investors who bought a stock or fund only to see its value plummet. Investors with unrealized losses often grow increasingly convinced that, in time, their stocks will roar back and their choices will be vindicated. They desperately linger on the notion that a loss is not really a loss until it is realized. Unable to admit to error, many an investor has ended up holding stock in a bankrupt company.

The same behavior applies to forecasters who stake out strong bullish or bearish positions. Once an opinion on a stock is given publicly, analysts or forecasters hesitate to change their stated position.²

According to Professor Statman, people tend to feel sorrow and grief after making an error in judgment. Investors deciding whether to sell a security are emotionally affected by whether the security was bought at more or less than the current price. Perhaps it’s the syndrome of “I’d rather be right than rich” that keeps the investor in a bad stock, or facing the embarrassment that your accountant will see, in black and white, your failure in the market.

Another way investors cope with portfolio losses is simply to ignore them. In an article entitled “When It Hurts Too Much to Look,” the Wall Street Journal reported that in good times people enjoy looking at their investment statements, but in bad, many let them pile up unopened and unread. That is because investors are afflicted with loss aversion and come up with elaborate mental constructs, such as “it’s only a paper loss,” to reduce their pain.

“Not opening the envelope takes the suspension of disbelief one step further,” says Hersh Shefrin, a professor of finance and economics at Santa Clara University. “It makes financial 30reality less salient. There are many studies that show that out of sight really can be out of mind.”³

To avoid the pain and regret of an independent bad decision, many investors follow the crowd, buying the media’s latest darlings. It is easier to go down with the ship along with everyone else who bought a ticket on the same Titanic stock cruise.

The old adage “the pride goeth before the fall” could not have stood the test of time without our help. A fascinating aspect of human behavior is that people are overconfident in their own abilities. Investors and analysts who have some knowledge, education, or training are particularly overconfident. For example, analysts will frequently exaggerate the reliability of their forecasts. If they say it loud enough, often enough, and with absolute certainty, they seem to believe the market will hear and conform itself to their mental prowess. Tversky calls this phenomenon the “illusion of validity.” Tversky asserts that “People are prone to experience much confidence in highly fallible judgment. Like other perceptual and judgmental errors, the illusion of validity persists even when its illusionary character is recognized.”⁴

Richard Thayler of the University of Chicago conducted an experiment on human behavior in his classroom. He concluded that people are more willing to take risks and gamble when they’re ahead on a stock. When the investment has dropped in value they become more conservative. Many people have similar feelings when they go to a casino. Thayler describes this as the “house money” effect.⁵

People hear what they want to hear. During the dot-com frenzy, many investors listened to the analysts projecting ever-increasing share prices for Internet companies. Yet there were plenty of quicksand warnings posted: overvaluation, lack of profits, unsound expansion strategies. But those warnings went unheeded by scores of investors. 31

People tend to fall prey to what psychologists call a confirmation bias—a kind of mental filter that takes in information consistent with a person’s beliefs and screens out inconsistent or conflicting information.⁶ This problem of human psychology is not unique to the investment field. Robert Park, a physicist, discussing the faulty research on electromagnetic fields states, “It’s not deliberate fraud… people are awfully good at fooling themselves. They’re so sure they know the answer that they don’t want to confuse people with ugly looking data.”⁷

Equally as perplexing as ignoring facts they don’t want to hear, the frequent trading by investors has puzzled many researchers. The buyer and seller in a speculative trade both believe they are acting on superior information. Like the next person to walk up to a recently vacated slot machine, they believe their nickel will cause the machine to hit the jackpot. People often make buy or sell decisions on information they believe to be superior, when in fact it is not, and has actually been debunked by the market itself. They look at their own decision-making process as superior and rational while feeling that everyone else is out to lunch.

Terrance Odean of the University of California–Davis analyzed trading records for 10,000 accounts at a large discount brokerage firm. Professor Odean found that on average, purchased stocks performed worse than the stocks that were sold. The investor would have been better off leaving the portfolio alone. This was true even when trading was not motivated by liquidity demands, tax-loss selling, portfolio rebalancing, or a move to lower-risk securities—in other words, when it was purely an investment decision.

In addition, he found that on any given day an investor is two times more likely to sell a stock that has gone up rather than one that has gone down. Professor Odean concluded that excessive trading by investors contributes to their under-performance and is caused by factors that include overconfidence, too much reliance on outside information such as 32analyst reports, and a reluctance to sell losing positions.⁸ Essentially, these investors are holding their losses and selling their profits. They’ll keep trading until they get a losing stock, and then keep it.

Day Trading—the Minute-by-Minute Market

The technology revolution and the Internet, along with the 1990s bull market, made day trading part of the American culture. Day traders attempt to make profits on small changes in the prices of stocks. They are known as day traders because they are taught to close out their positions by the end of the day. Day trading firms provide computer terminals and sophisticated software to track stock prices via dedicated-line access to the market. Only a few years prior, this type of system was limited to brokerage firms. Today, anyone can become a day trader.

In August 1999 Time magazine published an article entitled “Day Trading: It’s a Brutal World,” which estimated that the number of folks who quit their jobs to become full-time day traders was about 5,000. But if you add those who trade online at home or between meetings at the office, there are as many as 5 million. The technology made it possible, and the bull market made it irresistible.

The article quoted Jake Bernstein, author of The Compleat Day Trader, who said that only about 15 percent of those who take up day trading make money at it. Many lose big because they don’t have the discipline to sell immediately when a stock moves against them, or they sell too soon when a stock moves their way. “If you have a lot at risk you are prone to acting on emotion,” Bernstein said, “and emotional decisions are likely to be bad decisions.”

A successful trader has to be able to stay calm while absorbing painful losses, according to Ari Kiev, a psychiatrist and trading coach also quoted in the Time article: “You start to lose, and you try to make it back, but you lose more. You lose the 33college money and then the rent money. That activates feelings of inadequacy, failure, and catastrophe. You start blaming everyone but yourself. It’s very destructive.”⁹

The interesting thing about the day trading phenomenon is how attractive it seems to the average person. Even when the risks are outlined and understood, many people forge ahead believing that they are more intelligent than everybody else. In addition, the element of high risk adds excitement to the process. I had three clients who took a portion of their wealth and did day trading on their own during 1999 despite my cautionary counsel. Two of the three lost everything, while the third was down by 90 percent. All of this occurred in a matter of less than six months.

What Type of Investor Are You?

Individuals and institutions often hire full-service broker/ adviser professionals to manage equity investments. Overwhelmed by the thousands of investment possibilities, such investors seek help with the decision-making process. Researchers theorize that the investment adviser plays a very important role in the process—that of the scapegoat.

In the book Fortune and Folly: The Wealth and Power of Institutional Investing, the authors conclude that officers and directors of large pension plans hire outside investment managers for no other reason than to provide cover in the event of underperformance. If the fund tanks, the financial adviser is fired; if it flourishes, the directors’ wisdom and the financial manager’s acumen are lauded. Of course, this same logic holds true for the individual investor. Individual investors will congratulate themselves on their ability to pick an adviser who shows good performance and use the adviser as the scapegoat for poor performance.¹⁰

In many ways, individuals are unique and exhibit their own distinctive behavior. But according to the banking industry, 34individual investors can be divided into three categories. An investor is either control oriented, making all the decisions and not needing any advice or direction, or passive, handing over the keys to the kingdom to a third party. Between those two extremes are the participative investors, who seek professional advice but remain involved in the decision-making process. Factors of personality, financial wealth, and age provide important overlays to this categorization process.

For example, investors tend to be more control oriented in earlier years, which makes sense. They have discretionary income; they’re more on top of their game intellectually and energywise; they’re climbing the corporate ladder. But in retirement, investors often become passive. They’d rather be on the golf course or reading a good book than poring over the intricacies of annual reports.¹¹

When it comes to gender, who are the real risk takers—men or women? No surprises here. Psychographics—the interconnection between demographics and psychological perspective—has proven that women tend to be more risk averse than men and are comfortable being passive investors. Marketing studies also indicate that men tend to be more active as well as control oriented and enjoy taking risks. But it has also been proven that women generally show superior investment performance relative to the opposite sex.

Bailard, Biel and Kaiser, an investment advisory firm, divides investors into five categories. Adventurers are the risk takers and are particularly difficult to advise. Celebrities like to be where the action is and are easy prey for fast-talking salespeople. Individualists tend to avoid extreme risk, do their own research, and try to act rationally. Guardians are typically older, more careful, and more risk averse. Straight Arrows fall between the other four personalities and are typically well balanced.¹²

Under this categorization, the Adventurers and Celebrities “play” the market as a source of entertainment and realize that 35it is just another form of gambling. It’s the Individualists, the Guardians, and the Straight Arrows who feel they are forced to play the game and unwittingly take on much more risk than they may realize. They are especially irritated with the fluctuations of the market and would love to have a better way to invest.

THE MADNESS OF CROWDS

Market Mania

Yale University economist Robert Shiller wrote a book entitled Irrational Exuberance, named after Alan Greenspan’s memorable phrase in a speech given in December 1996. In painstaking detail, Shiller describes how the roaring bull market of the 1990s was nothing more than a speculative binge: irrational, self-propelled, and self-inflated.¹³

The astonishing run-up in prices had very little to do with earnings or dividend growth. Instead it was a reflection of human psychology—a kind of collective belief that financial gravity did not necessarily apply. Shiller notes that these same forces of human psychology can drive the markets into a downward spiral with equal disregard for economic data.

Shiller believes that there is a zeitgeist—a spirit of the times—when it comes to the market, and that it is an extremely powerful force. In the late 1990s everyone may have known, at least on a subconscious level, that the market was overvalued. But no one changed his or her behavior. The behavioral power of human forces that compel people to do what they do will always triumph. If the basic force is optimism or greed, the markets will remain exuberant. If the basic force is pessimism or fear, then no amount of earnings or dividend increases will assuage it.¹⁴

According to Shiller, human behavior is what drives prices, and you can throw the efficient-market theory out the window. The efficient-market theory asserts that financial prices 36accurately reflect all public information at all times. In other words, stocks are correctly priced at all times. This theory is to the economics and the financial profession what the belief in God is to the Catholic Church: an article of faith. Shiller insists that this fundamental assumption by the traditional financial community is totally wrong.

Shiller’s insight seems to fit what anyone can observe of today’s market. Stocks fluctuate up and down wildly based on the latest press release or international crisis or presidential speech. Logically, each publicly traded company is producing the same product and service as it was just minutes before the news, but the reaction of the investor is irrationally euphoric or catastrophically morose. Internet technology has made it too convenient for investors to make rash decisions based upon their emotional reactions.

In 1895 a French sociologist named Gustav Le Bon authored a book called The Crowd: A Study of the Popular Mind.¹⁵ Le Bon’s book was inspired by the political and social turmoil of his times. He asserted that the crowd was not driven by rational argument but by its spinal cord. It responded solely to emotional appeals and was incapable of thought or reason. Leaders of a group of people, he proposed, need to appeal not to logic but to unconscious motivation.

Le Bon’s book was written with the working class in mind, but by the 1920s his ideas were applied to virtually everyone. Almost no one is seen as capable of rational thought. The most efficient way to win hearts and minds is through emotional appeals. The modern industry of public relations is based upon this premise, and it applies to the politics of democratic government as well as to the investment industry where people are voting with their money.

Survey research, polling, and focus groups are all built around the science of tallying that emotional reaction. Since 37the 1920s this quantification of public feeling has gained credibility because media and corporate and political leaders give it credence. Today we see the public expressing itself as a kind of statistical applause track to the headlines of the day.¹⁶

In 1841 Charles Mackay wrote his classic work on crowd psychology, speculative bubbles, and manias. Entitled Extraordinary Popular Delusions and the Madness of Crowds, Mackay wrote, “Money, again, has been a cause of the delusions of the multitudes. Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper. Men, it has well been said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”¹⁷

All of the idiosyncrasies of individual investors can be magnified, creating dramatic bubbles of intense speculative activity. This is not peculiar to this age. There have been many financial bubbles since the publication of Mackay’s book in 1841. There was the great U.S. stock market bubble of the 1920s; the Japanese stock market and real estate bubble of the late 1980s; and the technology/Internet company bubble of the late 1990s, just to name a few.

John Kenneth Galbraith outlined the common denominators of past bubbles and manias in his 1993 book, A Short History of Financial Euphoria. They might be summarized as follows:

• There are those who are persuaded that some new price-enhancing circumstance is in control, and they expect the market to stay up and go up, perhaps indefinitely.
• Those involved with the speculation are experiencing an increase in wealth.… No one wishes to believe that this is fortuitous or undeserved; all wish to think that it is the result of their own superior insight or intuition. The very 38increase in values thus captures the thoughts and minds of those being rewarded.
• It is said that [those who express doubt] are unable, because of defective imagination or other mental inadequacy, to grasp the new and rewarding circumstances that sustain and secure the increase in values.
• The speculative episode always ends not with a whimper but with a bang.¹⁸

In the late 1990s, after these prophetic words were written, we experienced financial euphoria followed by a period of despair that laid many investment portfolios to waste.

INVESTING OR GAMBLING?

From my perspective, the stock market is just a game, little more than a gambling casino, a complicated amusement that is virtually impossible to beat over the long run. Why then do so many people play the game?

Some games are purely games of chance. Rolling dice takes absolutely no skill, and the outcome is based solely on luck. However, some card players are genuine professionals, and the outcome depends on skill as well as luck. The successful gambling professionals use laws of probability to their advantage.

People play the stock market game because they feel that they can beat the competition (other investors) through a combination of skill and luck. Whether they do it themselves, place money in managed mutual funds, or have an investment adviser select equities or funds for them, the objective is to beat the market. Like it or not, these kinds of investments—conservative 39or risky—are a gamble. Why? Because there is no preestablished protection against loss. A stock portfolio can slide to zero.

A pervading myth—one vigorously promoted by Wall Street and corporate America but increasingly found suspect by burned investors—is that stock market investing is the only reasonable way to make money and beat inflation. But this is simply not true. We are not all trapped in some kind of investors’ casino with the doors locked and Lady Luck spinning the wheels. We can recognize that stocks can seemingly go sky high as well as free-fall into oblivion depending upon a wide variety of circumstances that are beyond our control. There are strategies and specific types of investments that allow investors to stop gambling with their principal yet participate in the market when it’s going up. These are discussed in Parts II and III.

Why is it that since the beginning of time, gambling has been such a popular pastime and often an addiction? Everyone— from the most desperate to the most respectable—seems to engage in it.

Gambling’s presence in American life is nothing new. In 1850, for instance, New York City boasted one gambling hall for every eighty-five residents. Nor is it particularly novel that state legislatures have grown addicted to lottery finance. In 1832 the revenues from lotteries that were run by eight eastern states dwarfed the federal budget by a factor of four.¹⁹

Today, the casino gambling industry is a $50 billion business, and it’s growing. In 1988 casino gambling was legal in only two states: Nevada and New Jersey. In 1994 casinos were either authorized or operating in twenty-three states. Forty-eight states now have some form of legalized gambling (Hawaii and Utah excluded). Americans currently bet over $650 billion a year on legal gambling. The industry’s take from this amounts to $250 for every American, or $750 a head for the third of the population that participates every year.

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In the year 2000, over 34 million people visited Las Vegas, and 127 million more frequented casinos nationally. This was the year when Americans’ spending on gambling exceeded money spent on almost all other sports and entertainment combined.²⁰ From 1976 to 1998 there has been a fortyfold growth in American betting. These figures do not include any consideration for the gambling that takes place in the stock market.

To attract all this business, the payoff should be great, but this is not the case, and everyone knows it. State lotteries return on average only 40 percent to 60 percent of the ticket price to bettors. Blackjack returns 99.5 percent, craps returns 98.6 percent, slot machines, 95 percent, American roulette, 94.7 percent, and pari-mutuel sports betting, 91 percent.²¹

Depending on who is counting, about one in every twenty Americans has some kind of gambling problem. The most serious addicts leave carnage in their wake—everything from domestic violence and crime to suicide. Statistics show that 5 percent of Americans buy 51 percent of all lottery tickets.²²

Available research shows that a person’s economic status tends to determine the psychological and financial meaning of gambling for that person. Higher-income people see gambling as entertainment and a way to socialize with other people. Conversely, the lower the income, the more gambling is seen as a form of investment. For the poor who have few alternative ways to invest, gambling is seen less as play and more as a serious chance to transform their lives. Additional evidence indicates that lower-income people spend a much greater percentage of their income on gambling than higher-income people.²³

I’ve had numerous calls over the years from people with low income and negative to zero net worth who wanted to place a good portion, if not all, of their meager savings into a “hot tip” that they received. The “tip” was usually from a relative or 41coworker who received a cold call from a broker pushing a low-priced stock. I would try to counsel these people away from such a risk and recommend they use their money to pay off their 18 percent interest credit card debt. That would provide them with a guaranteed 18 percent return. Some took my advice. Others really wanted to buy that stock and do it as quickly as possible. I’m sure they found a firm to execute the transaction for them. I think most of those people would have done better at the blackjack table in Las Vegas.

People’s infatuation with gambling obviously does not take into account statistics or probability to determine the odds of winning, or no one would play the game. It all comes down to the minutiae relating to human behavior. Gamblers don’t care that the odds are stacked against them. As a matter of fact it presents a challenge to overcome. They have a powerful ally: Lady Luck will interpose herself between them and the laws of probability and bring forth victory.

Adam Smith, the father of capitalism and a master of the subtleties of human nature, attributed the gambler’s motivation to “the overwhelming conceit which the greater part of men have of their own abilities and their absurd presumption in their own good fortune.”²⁴ This was written over 200 years ago, but it aptly describes the overconfidence that individuals exhibit today.

FACING THE REALITY

The financial markets, including equity prices, are driven by supply and demand. This in turn is determined as a result of decisions made by human beings. These decisions are based not only on rational measures but also on a complex set of emotional factors. As a result, the market’s actions are a reflection of human emotions that range from despair, gloominess, and misery to outright enthusiasm and exuberance. These feelings can turn on a dime, and consequently, so do the markets. 42

Studies in behavioral finance have proven that human behavior is irrational and unpredictable when it comes to money. Therefore, the task of predicting the direction of the financial markets, much less individual stocks, with a high degree of confidence will always be a formidable undertaking.

Over the years I have observed many situations in which individuals come into a large sum of money, either from an inheritance, settlement of a lawsuit, sale of a piece of property, the lottery, or any other windfall. I have seen beneficiaries at one end of the spectrum immediately dispose of everything they receive via reckless spending, lavish gifts, and so on, while others at the opposite end of the spectrum hoard every penny in a low-interest savings account. For those who place it in the market through individual stock or mutual fund purchases or even via a professional money manager, the worst thing that can happen in my opinion is that they make a quick profit. Then it seems like easy money, and it creates unwarranted confidence in themselves and the system. As a result, more money is poured in without due consideration to the risks of doing so. In the long run it’s actually better for the investor to experience a loss and learn right up front the very tangible risk of playing the money game with stocks or mutual funds.

As investors we have to recognize that our individual emotional behavior can be our own worst enemy. If we can accept this rather humbling assessment, we can explore alternative investment strategies with more realistic expectations.

I think that playing the stock market game is for the 25 percent to 30 percent of individuals in this country who are avid gamblers. It’s a great place to fully express the fact that you are a risk taker and that you wouldn’t have it any other way. It’s also more 43socially acceptable to brag about your keen insight in selecting a winning stock or fund than showing off the suitcase of money you won from the craps table in Vegas. If you end up losing money in the stock market, at least you can write off the loss on your personal income tax return (with certain limitations), while a loss at the casino can only be used to offset your winnings. If you are really into it, you can become a day trader or, even better, become a mutual fund manager, where you can gamble with other people’s money.

What about the other 70 percent to 75 percent who are not gamblers? Many investors play the game because they know of no better alternative. They stick with the conventional wisdom. Here is a quote directly from the book Making the Most of Your Money, by Jane Bryant Quinn, which is representative of this conformist thinking:

The cheerleading on behalf of stocks as the best investment choice over the long run is epitomized by this quote from the best-selling book, The 9 Steps to Financial Freedom, by Suze Orman:

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It’s these kinds of statements that give people a false sense of security about the stock market. Orman should consider that in September 1968 the S&P 500 index was at 102.67. In September of 1978, ten years later, the index was at 102.54. Even when you consider dividends, there would have been many better places to put money during this period of time, such as bonds and real estate.

There is a better alternative, but it took me some time to reprogram my thinking away from the accepted tradition. I was thoroughly trained to embrace this philosophy of long-term investing and its supposedly irrefutable wisdom.