Book Review: Why Smart People Make Big Money Mistakes 02/13/2005

Book Review

Why Smart People Make Big Money Mistakes
And How to Correct Them
by Joseph Dancy
LSGI Advisors, Inc.
February 13, 2005

Why Smart People Make Big Money Mistakes
And How to Correct Them
by Gary Belsky & Thomas Gilovich
224 pages, Simon & Schuster; 1 Fireside edition (April 6, 2000)
List: $12.00; $9.00 at Amazon.com

Book Cover Investment Lessons From Studies in Behavioral Finance
Review by: Joseph Dancy, LSGI Advisors Inc.

Psychology professor Thomas Gilovich and financial journalist Gary Belsky team up to analyze the latest studies in behavioral finance and how psychology impacts the investor in an interesting book entitled "Why Smart People Make Big Money Mistakes - And How To Correct Them."

The book does a skillful job examining common issues and decisions faced by all investors - and offers suggestions as to how to deal with these behavioral issues as an investor.

Losses Hurt More Than Gains Please

One of the central principles of behavioral economics is that most people are "loss adverse" - that is "the pain people feel from losing $100 is much greater than the pleasure they experience from gaining the same amount." For this reason investors many times will behave inconsistently when taking investment risks, which will skew their decision making process.

Because of the psychological "pain" caused by potential losses many investors prefer to invest for a certain gain, however small, over a highly probable chance to obtain a much larger gain. This tendency translates into a portfolio that overweights fixed income investments over stocks. In the longer term after inflation is considered, the authors claim that this loss aversion is costly to many investors.

Studies have shown that investors are too eager to sell stocks that have done well, "booking" or "locking in" the gain. Selling avoids the discomfort of potentially experiencing a future loss, but many studies indicate that these stocks tend to continue to outperform.

Other studies have shown that investors are too slow to sell stocks that have gone down in price or have not performed well, with the investor hoping that they will "come back" so they can �breakeven.� The investor rationale is that a loss is really not a loss until the sale occurs, at which time the loss (and pain) are "final." The fact that investors are more likely to sell winners too early, and hold the losers too long, has been termed the "disposition effect" by academics.

Herd Behavior

The authors note that investors, and individuals, tend to get caught up in the latest trends and tend to exhibit what they refer to as "herd behavior." They note "as an increasing number of people become involved in the stock market . . . they are often thrown into situations about which they know very little and about which they are subjected to various and competing sorts of advice."

They continue: "Doing what everyone else does is not an unreasonable alternative in that situation, and it has a bonus allure: If your decision turns out to be unwise, you can at least comfort yourself with the knowledge that a lot of other people made the same decision . . . the more uncertain people are - and the higher the stakes involved - the more vulnerable they are to the sort of cue taking that leads to herd behavior."

Numerous studies have shown in the short run this herd behavior has caused investors to grossly overstate, or understate, the true enterprise value of the underlying business according to the authors. "Powerful information cascades lead people to sell simply because other people are selling, or to buy because other people are buying," and since the price of stocks are "set at the margins of shareholder ownership" according to the authors, many times they will not represent the true value of the business.

Investment Suggestions

After reviewing the recent studies on behavioral finance issues the authors have several suggestions for the average investor:

Most mutual fund managers fail to outperform the major indexes over time. As such, the authors advise most individuals to avoid investing in mutual funds and recommend that they invest in index funds instead.
The authors note: "Any individual who is not professionally occupied in the financial services industry and who in any way attempts to actively manage an investment portfolio is probably suffering from overconfidence .. . . Such people . . . should simply divide their money among several index funds and turn off CNBC."
If an individual decides to actively manage a portfolio they should take advantage of the market inefficiencies created by the herd behavior and overconfidence of other investors. Since short term stock prices can be significantly different than the underlying value of the enterprise, investment positions can be acquired in temporarily out-of-favor firms that are well below the real long term enterprise value. The authors note that one school of investing that takes advantages of these inefficiencies is describes as "value investing" - and includes notable investors such as Ben Graham, Warren Buffett, John Neff, and David Dreman.

The authors conclude that behavioral tendencies cause the market to be inefficient in the short run. They claim that some of the world's best investors have historically taken advantage of these inefficiencies by using a value-driven strategy to select long term equity holdings.

Contact Information
Joseph Dancy, Adjunct Professor
Oil & Gas Law, SMU School of Law
Advisor, LSGI Market Letter
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