<THE RULE BREAKER PORTFOLIO>

Are You Checking the Box?
The Psychology of Investing, IV

By David Gardner (MotleyFool)

ALEXANDRIA, VA (June 9, 1999) -- The Rule Breaker portfolio, whose stated aim is to take strong, smart risk in order to maximize strong, smart reward, didn't fare too well today. We often don't. OK, so today we caught a 0.22% updraft, sure, just ahead of the S&P 500's 0.10%. Whatever. But the Nasdaq jumped sharply, 1.81%.

Our underperformance since an amazing high in April continues.

That's one way of "framing" it.

Another is to say that we remain well up for the year, or way up for history. It all depends on how you "frame" your timeframe, doesn't it?

Puts me in mind of "framing," a psychological concept we've been dealing with in our Psychology of Investing series. With so many new people coming to Fooldom each day, it may be a new concept to you, even though I only wrote about it on May 11. Anyway, here's a link there. We'll continue our series today.

But before we do that, I'm writing a week after my Amazon.BOMB piece, whose popularity has quite surprised me. What really caught the attention of most people is that I stated up front and very clearly that I had not read the Amazon.BOMB piece. There was no secret to this; I wasn't "admitting" this; in fact, it was the point of my piece. Most took this in the spirit it was intended, including a nice mention in The Industry Standard, extending me the "award for criticism" for the piece.

Anyway, the point of the piece was that when it comes to Internet analysis and insight, Barron's editorial is simply not worth reading. Believe me, I have read LOTS of it in the past; those familiar with my analysis of Barron's included in Rule Breakers, Rule Makers know that I am eminently familiar with their editorial viewpoint. Some people on our message boards made a big point of saying, "He didn't read it!" and that I was a very Wise fellow for criticizing something I hadn't read. But again, my intention was not to debate Barrons's points one-by-one; if you wanted that, you had outstanding articles here at fool.com from the likes of Louis Corrigan and Dale Wettlaufer (you can read those here). My own point was quite different.

Switching gears, for me this weekend's Motley Fool Radio Show comes with a high degree of anticipation, because one of our guests will be John Allen Paulos. Mr. Paulos, to those not already familiar with him, is an author and mathematics professor who loves to analyze our inability to make sense of numbers, and the psychology that lurks behind that. We're having Mr. Paulos on the show to share some of his own anecdotes and ideas relating to "The Psychology of Investing," mainly because both we and you (judging from the voluminous message-board reactions) find the topic extremely interesting.

In fact, before I go further in this article, let me invite you to submit to our Rule Breaker message board any questions you'd like to see answered by Mr. Paulos directly on the show.

Mr. Paulos's first book was Innumeracy, and he followed it up with A Mathematician Reads the Newspaper. His latest book is Once Upon a Number: The Hidden Mathematical Logic of Stories. (But I'd start with Innumeracy, if you're interested.)

Past Psychology of Investing series entries have related to framing, anchoring, and typicality. Tonight, in honor and anticipation of Mr. Paulos hangin' out with us on The Motley Fool Radio Show, I'd like to examine an anecdote he provides on page 117 of A Mathematician Reads the Newspaper. He writes:

"In a perverse mood, I informed one of my classes early in the semester of a new rule: Anyone who checked a box on the exam sheet would have an extra ten points added to his or her exam score, unless the number of students checking the box constituted more than half the class. If more than half the class checked the box, those checking it would have ten points deducted from their exam scores."

What do you think happened? Those aware of the fundamental risk-aversity that is part of human nature probably have a leg up on answering the question.

At first, very few people checked the box. "Hey, I think I'll get an A anyway -- why should I risk getting a B off of some lucky extra-credit challenge?" For most students, the risk of losing outpaced the reward of winning.

However, as Paulos writes, "The students were concerned about their rank in the class, [so that] even those who didn't wish to gamble had to take the actions of their fellow students into account in deciding whether to check the box."

You can probably imagine what happened then. Word of the success of their fellow students -- those who took the risk to check the box -- spread. "It worked for Sam!" someone mused, about an otherwise mediocre math student. Ah, but that second time around, most people still wouldn't check the box, figuring the success of the strategy would be short-lived, as word spread.

So it kept working.

Eventually though, as Paulos writes, "What happened is that progressively more students checked the box on the exam sheets as the semester wore on, until on one exam more than half the class checked the box and these students were penalized ten points. Very few students checked the box thereafter."

Now, as we are wont to do in the "Psychology of Investing" series here in Rule Breakerdom, let us apply the lessons learned from Paulos's inventive and devious experiment to the stock market.

Here, we may imagine that the "box checked" is analogous to "investing in the stock market"; checking the box is buying stock. At first, few are willing to do so, and those who do take the risk (which is essentially against mass human nature) are rewarded. Over time, more people buy in (check the box) and are all rewarded. But at a certain point, our analogy suggests, a large number of people will buy into the market, and everyone will "lose ten points."

This is a very interesting application of the principle "The pain of loss is three times the joy of gain," which I first read about in The Universe and the Teacup, but has been documented in numerous similar psychological studies. Basically, gaining 10% on your stocks is, for most people, about three times less influential than losing 10% on their stocks -- even though the same amount of money is involved. This is the reason behind few people initially checking Paulos's tempting little box. After a while, as the risk aversity breaks down and more people are willing to "gamble," more are rewarded. But the way he set up his experiment, once too many do this, everyone is burnt and we return to the initial state of risk-aversity, where few will check that box.

How fair and "true" is it, to apply this anecdote to the stock market? A great question. I'd love to hear what you think. Here's what I think.

First, the stock market does not have any fixed mechanism where once X% of people invest, it will then drop X% due to their over-enthusiasm. The stock market is ultimately based both on investor perceptions and corporate profits. The latter have shown an unerring ability to rise steadily over time.

Second, there is no specific limit (of which I am aware) that anyone has determined that shows what "X" equals, when we speak of X% of people investing. Are we "too over-enthusiastic" -- too bullish -- when 50% of America owns stocks, or 20%, or 95%, or what? I'm not sure there IS any answer to this question.

Some people seem to believe there is one, though. Today, we repeatedly come across mentions from them of "bubbles" and "tulips." These threadbare comparisons shed very little insight on the state of our markets, but all hint at the notion that "too many people are investing," investing is "not that easy," etc.

But as BDKliewer points out on our message boards, the Dutch tulip craze involved an underlying investment that had no ability to generate cash flow, quite unlike (in our case) the Internet. And the South Seas "bubble" popped because of fraud.

Of course, I think it is very helpful to remain cognizant of the potential that the stock market MAY work like Paulos's little checked box. Fools have open minds, and should ideally admit to many more possibilities than most people have even thought of.

All these things said, the more people I see using the mindless examples of "tulips" and "bubbles," the better I feel about owning the stocks that I do. That's because these critics are engaging in cliched herd thinking -- the mindless application of mostly irrelevant historical examples as precedents. Plus, their herd thinking is made more and more evident by the frequency with which other people go on to hastily cite these same historical examples, as if they're offering striking and original analysis.

So consider this: Perhaps it is the Prophets of Tulips and Bubbles who are checking boxes. Ever considered that? The more people who buy into their analysis -- who check their boxes -- the closer the analysis gets to collapsing and losing them all "ten points."

Another ten points.

Because Internet bears have been losing points at a steeper and more rapid rate than perhaps any group of bears in history!

Anyway, all food for thought, and it's a pleasure to be able to share it and hear back from you. Now, off to play some Fool softball.

Fool on,

David Gardner

06/09/99 Close

Stock  Change    Bid 
------------------ 
AMGN  -1 1/2     57.75
AMZN  +2 7/16   114.00
AOL   +  5/16   110.69
ATHM  -  3/8     96.88
CAT   -  5/8     61.50
CHV   -  1/8     92.63
DD    -  11/16   68.81
DJT   +  5/16     5.50
EBAY  -  3/4    183.00
GT    -1 1/8     62.13
IOM   +  1/16     4.44
SBUX  -  1/2     34.81
TDFX  -  1/8     17.63

                  Day     Month  Year   History   Annualized 
      R-BREAKER  +0.22%  -5.74%  26.14% 1166.10%  68.90%
        S&P:     +0.10%   1.29%   7.59%  201.22%   25.57%
        NASDAQ:  +1.81%   1.98%  14.90%  249.82%   29.51%


    Rec'd    #  Security     In At       Now      Change
   8/5/94  2200 AmOnline       0.91    110.69   12078.85%
   9/9/97  1320 Amazon.com     6.58    114.00    1632.72%
  5/17/95  1960 Iomega Cor     1.28      4.44     246.57%
  2/26/99   300 eBay         100.53    183.00      82.04%
  12/4/98   450 @Home Corp    56.08     96.88      72.74%
  4/30/97 -1170*Trump*         8.47      5.50      35.06%
 12/16/98   580 Amgen         42.88     57.75      34.69%
  2/23/99   300 Caterpilla    46.96     61.50      30.95%
  2/23/99   290 Goodyear T    48.72     62.13      27.53%
   7/2/98   470 Starbucks     27.95     34.81      24.53%
  2/23/99   180 Chevron       79.17     92.63      17.00%
  2/20/98   260 DuPont        58.84     68.81      16.94%
   1/8/98   425 3Dfx          25.67     17.63     -31.33%

    Rec'd    #  Security     In At     Value      Change
   8/5/94  2200 AmOnline    1999.47 243512.50  $241513.03
   9/9/97  1320 Amazon.com  8684.60 150480.00  $141795.40
  2/26/99   300 eBay       30158.00  54900.00   $24742.00
  12/4/98   450 @Home Corp 25236.13  43593.75   $18357.62
 12/16/98   580 Amgen      24867.50  33495.00    $8627.50
  5/17/95  1960 Iomega Cor  2509.60   8697.50    $6187.90
  2/23/99   300 Caterpilla 14089.25  18450.00    $4360.75
  2/23/99   290 Goodyear T 14127.38  18016.25    $3888.88
  4/30/97 -1170*Trump*     -9908.50  -6435.00    $3473.50
   7/2/98   470 Starbucks  13138.63  16361.88    $3223.25
  2/20/98   260 DuPont     15299.43  17891.25    $2591.82
  2/23/99   180 Chevron    14250.50  16672.50    $2422.00
   1/8/98   425 3Dfx       10908.63   7490.63   -$3418.00

                              CASH   $9924.87
                             TOTAL $633051.12
 
Note: The Rule Breaker Portfolio was launched on August 5, 1994, with $50,000. Additional cash is never added, all transactions are shared and explained publicly before being made, and returns are compared daily to the S&P 500 (including dividends in the yearly, historic and annualized returns). For a history of all transactions, please click here.

</THE RULE BREAKER PORTFOLIO>

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