Behavioral Finance 101 [Fool on the Hill] July 26, 2000

FOOL ON THE HILL: An Investment Opinion
Behavioral Finance 101

Over the last few months, certain companies that were once among the fastest growing in terms of market cap have been shunned by the investment community. One thing that was conspicuously absent from the discussions surrounding the crash of these companies was any reasoning as to why these companies' prospects had suddenly changed. Was it mass delusion? Is the market rational, or is it the amalgam of our collective incompetence?

By Bill Mann (TMF Otter)
July 26, 2000

In the months since investors seem to have collectively awakened from a mass delusion about Internet stocks, we've seen announcements by several struggling companies that they are changing their business models. In a time that has seen a massive shift in investor priorities, this type of change should spell "danger." It means that the company is making a move in desperation -- never a warm and fuzzy sign.

The really interesting thing here is that, on a basic level, these companies are no different now than they were in February. They have the same ugly income statements, the same huge sales growth, and the same need to take on additional funds to survive. What's different is their balance sheets. They're running out of cash because the hitherto endless stream of capital from risk-averse investors has suddenly dried up. And unless the tide of investor sentiment turns, these companies are going to run out of money.

There are a couple of issues that we should think about here, but perhaps the largest is a notion that the collective investment decisions made show tendencies not of rationality, but, in the words of noted psychology scholar Peter Bernstein, "of inconsistency and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty." This is a powerful indictment of the theory of market efficiency, which supports the supposition that the market rationally takes into account all information available at a given moment. In layman's terms, various studies have concluded that Behavioral Finance postulates the following:

  • Individual and institutional investors are susceptible to herd mentality, a tendency at the root of many bubbles and crashes;
  • The pain of a dollar lost generally is much greater than the pleasure of a dollar gained;
  • People tend to take a self-centered approach to investing. That is, they put emotional weight in the price they paid for the stock relative to its current position;
  • Overconfident investors tend to trade too much and underperform the market;
  • People tend to be more optimistic when the market goes up and more pessimistic when it goes down;
  • People are afraid to admit an error in judgment and are thus more likely to sell winners in their portfolios than losers;
  • The confidence investors have in "growth companies" is often irrational, thus the historic outperformance by investors employing value investing.
Got all that? If you are like me, you read through this list and say: Yeah, I know a lot of people like that, but I'm not one of them. Well, maybe you aren't, and then again maybe you are. Ostensibly, if you are buying and selling individual stocks, you have the confidence that you are an above-average investor. And if you had enormous returns over the last year you have every reason to be proud of yourself.

But investors, particularly those who are new to the game, should not confuse a bull market with superior ability. Unless you only intend to invest for a one-year period and then quit, the returns you generated in 1999 are ultimately meaningless. Even more frightening is that there is a significant body of work suggesting that the confidence investors derive from short-term success will usually lead to long-term underperformance of the market in general, net of all trading costs.

I'm cribbing heavily from studies done by behavioral psychologists Daniel Kahnemann and Amos Tversky, as well as work by Business Professors Terrence Odean and Brad Barber from the University of California-Davis. Building on prior works and using 10,000 customer accounts at discount brokers, Odean and Barber found that the overconfident investor trades more, holds riskier portfolios than rational investors, expends more time, and still underperforms those less confident investors. But you'd never think that by spending any time on message boards, would you?

The role of discussion boards
When are discussion boards generating the most traffic, the most interest, and the most confidence? Primarily when the stock being discussed is rocketing to new highs. That's when the most noise starts to swirl. Is the stock going to split, is it going to run to $200, whatever.

It is also at these times when those who own the stock are least likely to either consider the risks or tolerate a dissenting opinion. The market price has validated their wisdom in picking the company, and the analyst upgrades (which interestingly rarely seem to come before a stock has its big run), the mentions on CNBC, the wonderful news stories, and the buzz of the next big move all create a powerful euphoria among those lucky enough to have invested.

This also happens to be the exact time when a prudent investor's guard should be up. When a company runs rampant in advance of some big happening, we should be at our most skeptical. As religious as Berkshire Hathaway (NYSE: BRK.A) shareholders can be about the company, I vividly remember some of the questions that were being posed when the stock ran up so fast in 1997-1998. They were insightful, and cognizant of the fact that Berkshire's intrinsic value was significantly below where the market was valuing the company at that moment.

I'm not talking about people who dislike a company or are holding shares short -- their negative sentiment has obvious sources. What you don't tend to find as much of is honest-to-goodness investors convinced of a company's excellence and discussing the assumptions being placed upon a company at such high valuations -- as well as the risks that would preclude those assumptions from coming to bear. Rather, investors tend to use the rise in price as a validation that they have access to superior information and a confidence that they have a better-than-average ability to interpret that information. But what does the implosion of Long Term Capital Management, run by Nobel Prize-winning economists, say about the infallibility of knowledge?

My question to those of you who loved Internet companies in 1999, is what information made you change your mind? It's as if everyone all at once looked up and realized that the vast majority of companies in this sector were losing money. CMGI (Nasdaq: CMGI) is a good example here -- a company with a business model that required it to make massive capital expenditures for the benefit of future growth. But all of the sudden the frothy IPO market dries up and the company is taken out back and shot. There is a certain euphoria in owning the fast-growth companies that disappears awfully quick when the stock turns the other direction.

The rational investor would have taken a sharp look at CMGI's valuation in March to identify the future earnings assumptions and the risks thereto. But it seems that the party was just too much fun. Those who really have been killed are the ones that got to the party late and bought at what turned out to be the high-water mark. And now it seems that you can't give CMGI away. Interesting, isn't it? Now that CMGI has much more significant room for share appreciation, very few people are interested. Strange, too, because CMGI remains an intriguing company.

This is not to say that the rational investor can call the highs or time the market. In fact, the opposite is true: The rational investor has the ability to focus on the business model and tune out the noise, including short-term price movements.

On Friday I'm going to revisit this topic and discuss how Behavioral Finance also has a negative impact upon Wall Street analysts, Mutual Fund Managers, and other professionals. In the meantime, look in your portfolio and see if there are any companies you bought for market reasons rather than business ones. Although there is much Foolishness in buying great companies, period, the path to the most profitability is to buy great companies at a time when the market undervalues them.

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards

For Part 2 of this article, please click here.

Related Links:

  • "The Psychology of Investing," Fool series by David Gardner
  • "Psychology and Behavioral Finance"
  • "Do Investors Trade Too Much?" by Terrance Odean