The market is one big head case. After the tear and tumble of Internet stocks, who can deny how intensely the power of suggestion works on investors? They're seduced by the markets, from tulips to technology. Seasons and days of the week sway them to buy or sell a stock. Academics have come up with a slew of diagnoses to explain their neuroses. And from that, a new breed of money manager has emerged--one who capitalizes on investor quirks.
"I can't outguess Warren Buffett, but I can stay one step ahead of the American multitudes," says Harvard University's Richard J. Zeckhauser, a behavioral economist who runs seminars on the topic. "Stock patterns emerge from common human behavior."
Wall Street traditionalists bank their bucks on such market data as earnings estimates, price-earnings ratios, and revenue growth. They subscribe to theories that say markets behave efficiently. Not so, say behavioral economists, whose ideas gained credibility in the 1990s. They maintain that the emotional baggage of investors can make markets go haywire, though reality eventually sets in. The ability to spot irrationality allows these managers to profit from market imperfections, betting that investors will return to their senses. And there's a lot investors can learn from these pros about how to keep their heads straight when investing.
One example of fear overpowering reason: Think back to November when recession jitters began. Prospects for retailers looked bleak, and stocks like Best Buy Inc. got hit. It fell to $22 from $55--a buy signal for behavioral manager David Dreman, chief investment officer of Dreman Value Management LLC, which oversees $5.7 billion. "You buy when the solid companies get knocked down too cheap," he says. Once investors saw the error of their ways, they bid Best Buy back up to a current $53. The stock stars in the 48.6% one-year return for the Scudder-Dreman High Return Fund.
ON AUTOPILOT. Behaviorists say investors tend to latch on to extremes, too. Down or up trends are etched in their minds as certainties, rather than mere probabilities. Take Cisco Systems Inc. (CSCO ) The stock zoomed for years, delivering double-digit returns. Investors got used to it, and expected history to repeat itself. Last year, when the stock began to fall as evidence emerged that business was shaky, many investors went into denial, refusing to let go. "Investors have extrapolated Cisco's past performance too far into the future," says Josef Lakonishok, chief investment officer of LSV Asset Management. He is a behavioral finance professor at the University of Illinois who launched LSV in 1994 and now manages $7.5 billion for the likes of Caterpillar (CAT ) and Stanford.
Far too often, analysts--and investors who follow them--exhibit "anchoring" behavior. They get attached to inaccurate price targets and ignore evidence that they might be wrong. One might say that UBS/PaineWebber's analyst Walter Piecyk had a problem with anchoring: In December, 1999, Piecyk's "buy" rating for Qualcomm Inc. (QCOM ) caused the telecom stock to jump 30% in one day. At the time, the stock was trading at $659, a 52-week high. Piecyk held onto a $1,000 target for months despite the fact that the company was having problems. After a 4-for-1 stock split, shares now trade for $59, or a presplit price of $236. "We look for stocks where the analysts are anchored on their own prior forecasts and overconfident in their ability to predict the future," says Richard H. Thaler, a University of Chicago economist and partner at Fuller & Thaler Asset Management Inc., which manages $1.4 billion. Thaler doesn't forecast the market and has never owned Qualcomm: "We just try to forecast the errors of others."
FUTURE SHOCK. Stereotyping a company makes investors think it can't win. If a stock has been a dog for ages, they're conditioned to expect the worst and miss turnarounds. Thaler's $140 million Behavioral Growth Fund buys companies to which the market "underreacts." One of its top 10 holdings, Oakley Inc. (OO ), which makes athletic wear, is in the portfolio for an average cost of $11. While it languished for a while, new footwear lines and eyeglass designs eventually improved the bottom line. Earnings were double analysts' 2000 estimates. "This company slipped a number of years ago, and it was hardwired into investors heads," says Thaler fund manager Fred Stanske. "It came back from the dead." Once investors got the picture, they bid up the stock, doubling Stanske's investment.
Unlike Thaler, some behaviorists look at the big picture. Consultant Woody Dorsey, who counts Fidelity Investments among his clients, gauges investor reactions to macro events: a fall in interest rates or joblessness and earnings reports. His take: Investors have reacted far too favorably to Fed Chairman Alan Greenspan's rate cuts and are still too much in love with stocks. The market has not digested imminent threats of inflation and energy shocks. Once the onset of gas lines and too much liquidity hits the market--within a year--stocks will tumble. "We need to get to the opposite extreme of the bubble," says Dorsey, before market fundamentals start to turn up. "It's those last chapters [of the bear market] that always look worst." If Dorsey is right--and that's a big "if"--then level-headed investors should stay on the sidelines and wait for the real buying opportunity.
By Mara Der Hovanesian in New York