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WALL STREET, CALIFORNIA: Time for a Tuneup | INVESTOR
TUNEUP SPECIAL

Irrational Pastime

Studying the Whys Behind the Fallacies We Fall For

September 30, 1997|THOMAS S. MULLIGAN | TIMES STAFF WRITER

NEW YORK — When some investors march out to do battle with the markets, logic seems to go AWOL. People hoard their losers and dump their winners. They trade a dull nickel for four shiny pennies. Hoping to recoup a loss, they double up on risk and turn a modest defeat into a bloody rout.

There are a million ways to lose money, and some investors seem to be methodically working their way down the list. Consider the man in rural Harvard, Mass., who once had a fortune in the stock of Digital Equipment Corp., based in nearby Maynard.

When financial planner Dee Lee saw him in church recently and mentioned Digital, "his face went blank," she said.

Yes, he's still holding the stock; it just isn't worth a fortune anymore. As the crash of 1987 toppled Digital from its all-time high of $197.75, he held. As it slid to $100 in 1989, to $50 in 1992, to $19 in 1994, he held.

In early 1996, Digital briefly rallied above $70 but has never come close to that since. During the '90s, in fact, the stock has averaged in the mid-$40s, right where it is today.

"You can tell people about the opportunity cost of holding on to a bad stock, the money they're losing by not investing in something else," Lee said. "Sometimes they just won't sell."

The prevailing wisdom among economists is that markets are efficient and rational--they reflect the collective activity of investors who instantly soak up all the available information and focus unswervingly on maximizing their gains.

But how do you account for irrational investors?

"I don't call them irrational," said Meir Statman, a finance professor at Santa Clara University. "I call them normal. You can never confuse a rational person; such a person is nonexistent."

Statman is one of a number of researchers tilling a relatively new academic field known as behavioral finance. Their aim is to identify and explain investor behavior that doesn't fit the rational model.

Critics think it's a fruitless effort.

Economist Merton H. Miller, a Nobel laureate from the University of Chicago, has little use for behavioral finance because to him it describes only what the losers are doing.

Because every transaction also has a winner, the net effect is a wash, Miller said in a recent interview.

"Unless it has an effect on the overall level of prices, it doesn't matter," he said.

Statman counters that some investor errors--overtrading, for example--lead to real waste.

"Suppose I jump in and out of stocks," he said. "It's true that I may be getting a fair price for any particular transaction, but I am wasting a lot of my time and money in commissions. For the economy as a whole, it's a dead-weight loss. It's the equivalent of loading and unloading a truck."

Moreover, apart from whatever effect it may have on the overall economy, knowing a bit about your own psychology may help keep you from making some elementary mistakes.

Statman believes that two of the most powerful forces driving investors are pride and regret.

The Digital investor can't bring himself to sell because that would mean finally owning up to a loss and exposing himself to the agony of regret. As long as he holds on, he can nourish the dream that Digital will one day recover its competitive position and get him back to even on his investment.

Statman had a piece of advice for the man's advisor: "If she's really crafty, she could tell him: 'Sell it. If it goes wrong, you can blame me.' "

Financial planners and full-service brokers won't like to hear it, but Statman thinks that one of their most important functions is to serve as scapegoats for their clients.

If their advice results in a profit, they shouldn't expect any praise, and if it results in a loss, they should expect to shoulder full blame. Only in that way can the client enjoy the pride of successful investments and be shielded from most of the regret for the ones that don't work out.

"It's never stupid me," said Statman, "it's my stupid advisor."

Another common way investors shield themselves from regret is by buying the stock of "good" companies, the ones that always show up in Fortune's annual survey of firms most admired by corporate executives.

Everybody knows that Coca-Cola Co. is a terrific company, the reasoning goes, so how can I possibly be faulted for buying Coke stock? If my stock in some obscure small company falls, that's my dumb investment, but if Coke falls, why, that's an act of God!

The fallacy, of course, is that good companies aren't always good investments. As Coca-Cola investors found out this summer when the stock--trading at more than 40 times expected earnings--finally tumbled, the stock of a good company can also be overpriced.

Although failing to act when action is necessary--taking a loss, for example--can be a problem, there are plenty of occasions when sitting still is the best policy.

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