Mysteries of Investing Revealed, Part 2

Investing for the Financially Challenged: How to Become Rich Using Your Bankers Money
by Walter Updegrave

(Page 2 of 2)

Put these two tendencies together, and you get a phenomenon that Schlomo Benartzi of the University of California and University of Chicago's Richard Thaler call myopic loss aversion- loosely translated as being overly concerned with short-term setbacks. Benartzi and Thaler hypothesize that investors' fear of short-term losses may sabotage their long-term investment strategy by leading them to put too little of their money in stocks, which are prone to many short-term setbacks but nonetheless have the highest long-term returns. The idea is that our shortsightedness, so to speak, about losses prevents us from focusing on stocks' ability to generate superior long-term gains and makes us pay too much attention to the temporary dips in market prices.

The Overconfidence Trap: It's amazing how quickly we can go from feeling we know very little about investing to the certainty that we've got it mastered. But psychologists and behavioral economists have found that in many cases our investing mistakes are caused from our own overconfidence, especially when we believe we have information that gives us special insight, such as a hot tip from a friend or supposed expert. This feeling that we really know what we're talking about also arises when we're considering investing in a company we're familiar with or whose products or services we use.

Investment publications help foster this notion by supplying us with accounts of superstar investors like Peter Lynch, who supposedly invested in Dunkin' Donuts after he found he liked its coffee. (Of course, Lynch no doubt did tons of research on the company as well before he went from Dunkin' Donuts java to its stock.) But familiarity doesn't necessarily breed great stock picks. By investing in companies we know, we may be doing little more than satisfying an underlying need to feel comfortable about where we invest our cash.

For example, after examining the stock-ownership records of all seven of the Baby Bells (the regional Bell operating companies that resulted after AT&T was split up), Columbia University professor Gur Huberman found that in all but one state (Montana) more people hold shares of their local Baby Bell than any of the other six. What's more, in forty-four states the amount of money invested in the local Bells exceeded the average amount invested in "outsider" Bells by a margin of more than three to one.

Presumably the investors in each state bought their local Bell because they believed it was a better investment than the other Bells; otherwise why would they have chosen the local company? But all these investors can't be right; every local Bell can't be a better investment than the other six. What is probably at work here is the notion that investors who live in a particular state feel they know more about the companies in their area. This notion also probably explains why Apple Computer fans might be more likely to invest in Apple than Microsoft, or people who've had good luck with Whirlpool appliances might be inclined to buy Whirlpool stock.

The Herd Mentality Mind-Set: If you're at a cocktail party and during the evening three different people mention a terrific mutual fund they've invested in, would you be tempted to buy it yourself?

If you're like most people, you probably would, because researchers have found that we tend to invest with a herd mentality - that is, we often abdicate our independent judgment and instead rely heavily on the advice, opinions, and actions of others. Not even professional investors are immune to acting like sheep; indeed, they may be even more prone to it than novices. Finance professors Josef Lakonishok, Andrei Shleifer, and Robert Vishny have theorized that one of the reasons fund managers lag the S&P 500 so badly may be because they gravitate toward "glamour stocks" - that is, shares are already so popular with investors that they tend to be overpriced. So why would managers buy stocks that would seem to have limited potential for outsize gains? Well, the profs hypothesize that the managers may feel they'll have an easier time rationalizing mediocre performance as long as they stick to stocks that no one would ever doubt are good companies.

Problem is, the more you're willing to follow the crowd, the more likely you are to get swept up in investment fads that have little chance for long-term success, and the greater your chances of buying a hot stock or fund do your that might be a flash in the pan.

The Crystal Ball Pitfall: This foible probably wreaks the most havoc with investors' money. Investors have a knack for assuming that recent trends will continue indefinitely into the future. When an investment has had a phenomenal year, as gold funds did when they soared to average 90 percent gains in 1993, many investors see that as a sign to put their money into a winner. Indeed, that's why the funds that get high ratings from fund-tracking firms like Morningstar tend to attract the most cash flow from individual investors.

The same goes for stocks. The prices of stocks of companies that have posted rapidly grooving profits often get bid up to ever higher prices because the investors believe the company will keep churning out those earnings in the future just as it has in the past. In fact, there's little, if any, evidence that the mutual funds that came out on top in the past will continue to do so in the future. After their spectacular returns in 1993, for example, gold funds lost 12 percent in 1994, gained a modest 3 percent and 8 percent the next two years, and then dropped 43 percent in 1997. Sizzle can turn to fizzle pretty quickly on Wall Street.

© 1999 by Walter Updegrave

About the Author

Many financial experts trace their interest in money to a gift of stock or mutual fund shares they received as a birthday or high-school graduation gift. Not me. No one in my family owned stock or mutual funds, let alone had enough to give away. My route to writing about investing was a bit more indirect.