http://biz.yahoo.com/mf/000726/hill_000726.html
> Wednesday July 26, 2:17 pm Eastern Time
>
> MotleyFool.com - Fool on the Hill
> Behavioral Finance 101
> By Bill Mann
>
> 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 - news) 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 - news) 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
--
Gerald Oskoboiny <
[email protected]>
http://impressive.net/people/gerald/