WHY INVESTORS MAKE THE WRONG CHOICES Recent psychological studies suggest that irrational fears cause bad buy-and-sell decisions. Knowing why can help you outwit the crowd.
By John J. Curran REPORTER ASSOCIATE Barbara Hetzer

(FORTUNE Magazine) – IN THE PURSUIT of wealth, investors face many foes: recession, bad management, product liability suits, even unscrupulous brokers. But none of these is as formidable, or as damaging to long-term results, as the quirks in investors' own mental machinery. In recent years psychologists have uncovered a surprising number of idiosyncrasies that can keep people from making the soundest choices in many situations. These lapses explain some of the mysterious up- and downdrafts that can lift and lower stock prices. Understanding them can make successful investing easier. Two Israeli-born psychologists, Daniel Kahneman, 52, of the University of California at Berkeley, and Amos Tversky, 49, of Stanford, are at the forefront of research into the human decision-making process. Their collaborative effort, which began 18 years ago at Hebrew University in Jerusalem, has not focused on investors in particular, but many of their startling insights apply to the decisions investors are constantly required to make. The U.S. Office of Naval Research, which seeks to understand better how its military commanders make critical decisions under the stress and disorder of battle, is a major supporter of the psychologists' work. Recently professional money managers, whose own decisions are made in a high-stakes environment, have begun to pay attention to the researchers' findings. Kahneman and Tversky have conducted elaborate psychological tests with subjects who were asked to choose between different pairs of risks and rewards. From these tests has emerged a new understanding of how people assess the probabilities of gains and losses. One of the most important findings arises from answers to a pair of questions. The first: If faced with the prospect of two possible gains, which would you choose? A 100% chance to win $3,000. An 80% chance to win $4,000. Asked this question, most people choose the guaranteed $3,000, even though the second choice has a higher value according to probability theory. The value is determined by multiplying the chance of winning, or 80%, by the $4,000 the winner stands to gain (80% of $4,000 is $3,200). So in the long run you come out ahead by making the second choice consistently. Most people are bothered by the 20% chance of getting nothing in the second choice, which tells psychologists what stock market theorists knew all along: that investors in general prize certainty and abhor risk. It's not that simple, however. When people are confronted with prospective losses, quirky psychology turns them into riverboat gamblers. That fresh discovery came clear from another question: Which would you choose? A certain loss of $3,000. An 80% chance of losing $4,000 and a 20% chance of losing nothing. Most people will gamble on the second choice, which offers a 20% chance of going unscathed, even though it is riskier (again, 80% of $4,000 is $3,200). Because people's horror of losses exceeds even their aversion to risks, say Kahneman and Tversky, they are willing to take risks -- even bad risks. ''Contrary to what's been believed,'' says Kahneman, ''risk aversion is not always the guiding light of decision-making.'' To measure just how deep the fear of loss runs, the psychologists followed up this pair of questions with another. Students were invited to wager on a hypothetical coin toss: Heads, you win $150; tails, you lose $100. Though the potential payoff is 1 1/2 times the possible loss, most students refused to bet. How can otherwise rational people act so unwisely in the face of promising moneymaking opportunities? Despite the outsize reward for taking this risk, the researchers say, most people are put off by the 50% chance of losing. ''Loss aversion is a surprisingly powerful emotion,'' says Kahneman. So great, in fact, that it keeps people from accepting good bets, both in coin flipping and in selecting stocks. One investment firm, Sanford C. Bernstein & Co., believes zealously in the gospel according to Kahneman and Tversky. ''Their findings go a long way toward explaining the psychological underpinnings of our investment philosophy,'' says President Lewis Sanders. In his view people's excessive aversion to losses helps explain why certain stocks become deeply undervalued in the marketplace. It also helps explain why his firm's investment strategy, which leads it to buy out-of-favor stocks, has yielded handsome rewards, with a few recent exceptions. Sanders says that as far as most investors are concerned, stocks of troubled companies are in the dreaded domain of losses. Investors can easily imagine that these stocks, already depressed, could decline still further. Even when the stock price drops to bargain-basement levels, investors steer clear. It's not just the powerful reluctance to lose that keeps most people from venturing into stocks that have sunk in price. Another emotional factor, called the fear of regret, can be equally paralyzing. Explains Meir Statman, an associate professor of finance at Santa Clara University who is applying Kahneman and Tversky's findings to the rationale of investor decisions: ''If you buy a depressed stock, say a steel company or an oil service company, and it declines further in price, you think, 'It was a loser to begin with. How could I have been so dumb?' But if you buy an admired stock, say IBM, and it declines, you consider it an act of God and you're blameless.'' STATMAN ARGUES that people will settle for mediocre performance from stocks that have good reputations just to avoid the possibility of regret. Conversely, they pass up the stocks of poorly regarded companies even if the stocks look cheap. Together with Hersh Shefrin, a Santa Clara professor of economics, Statman is in the midst of a study of the stocks of companies in FORTUNE's annual surveys of corporate reputations. Though the findings are not in, Statman's hunch is that stocks of the least admired companies are a better bet. The experience of Dean LeBaron, the investment chief at Batterymarch Financial Management, a Boston firm that runs $10 billion for pension funds and other clients, helps explain why. Several years ago LeBaron achieved splendid returns with a portfolio of companies in serious financial straits. He has his own homespun theory about investors' fear of regret. LeBaron calls his idea, which comes strikingly close to the psychologists' theories, the ''pride-shame relationship.'' He says investors tend to overvalue companies that they are proud to own and undervalue those that they are ashamed to own. ''It's the stocks that people are ashamed to own that have fallen to bargain levels,'' says LeBaron. ''While that may seem obvious, people avoid them.'' Even security analysts, who are trained as objective arbiters of value, are often loath to recommend poorly regarded companies. Notes Preston Estep, president of New Amsterdam Partners, a New York money management firm: ''Security analysts like to see their names next to stocks that are making new highs, not those that are making new lows.'' That way, he says, the analysts get quoted frequently in the financial press, their advice is sought out by the firm's clients, and their names and reputations are identified with a winner. Though professional analysts might think themselves above the prejudices that warp the average investor's thinking, they may in fact be even more susceptible. Kahneman concurs: ''For professionals to think that they are immune to these things is just silly.'' Investors willing to defy emotional groundswells of fear stand to outperform the crowd. But the rewards do not come quickly or easily. Because other investors continue to shun the stock of a troubled company, the price recovery is often slow and agonizing. Occasionally it never happens. The money managers at Sanford C. Bernstein have felt the pain that contrarian investing can bring. Since the firm bet heavily on depressed natural-resource and technology stocks at the beginning of 1985, the $6.5 billion in stock % portfolios it manages has scored an average total return of 27.5%, counting reinvested dividends -- less than the 31.8% total return on Standard & Poor's 500-stock index. Armed with the courage of its convictions, however, Bernstein is doggedly buying more of the same. Says Sanders: ''We are accustomed to a performance penalty on the front end. But we stay the course, and that enables us to cash in on the back end.'' As uncertainty about these troubled industries slowly diminishes, he predicts, investors will come back one by one at different stages of the recovery, and stock prices will climb. Notwithstanding its recent setbacks, Bernstein has enjoyed the last laugh many times in the longer haul. Over the past ten years its portfolios have returned investors 20.3% annually, vs. 14.3% for the S&P 500. While some mental demons can keep us from buying cheap stocks, others work the opposite way, nudging us into the wrong ones. People are miserable judges of remote possibilities, psychologists report. Consider the responses to another question by Kahneman and Tversky. Choose one: A 2% chance to win $3,000. A 1% chance to win $6,000. Both choices have exactly the same monetary value, $60, but people do not see it that way. The second choice, researchers found, won by a 2-to-1 margin. The less likely the long-term payoff, Kahneman and Tversky have concluded, the more our mental calculators break down and overestimate its probability. That, they say, is why people go on buying lottery tickets. In the stock market this syndrome can lead investors both to overvalue and to undervalue stocks. Some market watchers think that Genentech, a South San Francisco genetic-engineering company, is a prime example of overvaluation. Investor enthusiasm over Genentech's new heart treatment drug, t-PA, which is awaiting approval from the Food and Drug Administration, drove the stock from less than $30 per share in late 1985 to $98 per share in June, or 395 times earnings for the prior four quarters (see chart). Though analysts agree that the outlook for the drug is promising, most think that the price-earnings multiple is up in cloud cuckoo land. Surmises Sanders, whose firm will not touch the stock: ''Investors aren't betting that the new drug will be successful. They're betting on the remote possibility that it will be a blockbuster and will not encounter competition.'' Genentech's officers apparently take a more sober view. Starting in April, they were heavy sellers. THE TENDENCY to exaggerate remote possibilities often magnifies the effect of a single unlikely event. After the April 1986 nuclear accident at Chernobyl in the Soviet Union, the possibility of a similar debacle in the U.S. spooked investors. Stocks of utilities with nuclear plants, including those with good safety records, were hurt. An even more dramatic instance of investor overreaction: the 30% plunge in Union Carbide's stock within three weeks of the December 1984 tragedy at its chemical plant in Bhopal, India. In the immediate aftermath, few people were willing to consider the possibility that Union Carbide might reach an acceptable out-of-court settlement. It seemed far more likely to investors that Union Carbide would be hit with a devastating penalty. Cooler heads who bought the stock at its low turned a hefty profit even before the stock moved still higher on an unsuccessful takeover bid. In each case, most investors leaped to gloomy conclusions. Worse, they clung to them. When people have some degree of confidence in a company's prospects for recovery from a short-term setback, they jump at the chance to make a killing by buying a stock at its low. But most people have difficulty believing that such troubles may only be temporary. Notes Richard Thaler, a Cornell economist who is studying investor psychology: ''Investors tend to confuse temporary or cyclical trends with long-lasting trends.'' Kahneman and Tversky say that these analytical mistakes result from ''heuristics'' -- mental shortcuts that people take in processing information. When investors use these shortcuts, they can make costly errors of judgment. ONE OF THE CHIEF heuristic culprits is what psychologists call representativeness, a tendency to conclude that two things are the same if they have some similar characteristics, even if the similarities are superficial. For example, a person may trust someone solely because he looks like someone else who is honest. Investors often choose a mutual fund on the basis of good recent performance. In effect, they are concluding that because good recent performance is a characteristic of good money managers, good recent performance must mean that a money manager is talented. ''It could be good management,'' Tversky cautions, ''but it could just as easily be luck.'' Representativeness also leads many investors and analysts to assume that a few years of consistent earnings growth at a company portends many more good things to come. Representativeness, says Bernstein's Sanders, helps explain why stocks of oil service companies like Halliburton and Schlumberger have been in the cellar of late. Taking a mental shortcut, people conclude that the collapse in oil prices is permanent and thereby fail to recognize the possibility that human initiative will alter the situation. As the late Charles J. Rolo, author of Gaining on the Market, put it, ''No trend continues unchanged forever.'' Says Sanders: ''The same investors who failed to realize that spiraling oil prices would dampen demand, encourage output, and ultimately weaken prices now refuse to believe that falling prices will stimulate demand while discouraging non-OPEC production.'' Those developments, Sanders says, should lead to a price reversal that will turn oil stocks into gushers. A tendency to make too much of easily recallable examples, known to psychologists as availability, can also lead people astray. For example, a rash of divorces among your acquaintances may lead you to think that the divorce rate in your community is rising when in fact it is declining. Similarly, dire headlines can sway investor opinion far more than the underlying trends would warrant. No one can estimate the mathematical probability that a Latin American country will default on its foreign debt. Accordingly, people make guesses based on the latest news stories. In early 1984 anxiety about the debt bomb mounted greatly. The stock of Manufacturers Hanover, a major lender to Latin American countries, sank over five months from $41.50 to $22.50 per share even though the bank's basic financial strength had not changed. At its low the stock briefly offered investors a fat dividend yield of 13.5%. All these biases and defects in judgment, it appears, make the stock market a less efficient pricing mechanism than is widely believed. One economist whose findings cast doubt on the market's supposedly perfect rationality is Yale University's Robert Shiller, 40, who has studied the relative price volatility of stocks. If the market is truly efficient, stock prices should change only in response to information on shifts in the underlying value of companies. But that, Shiller found, is not always the case. Together with John Pound, formerly a senior economist at the Securities and Exchange Commission, Shiller recently polled two groups of institutional investors on their reasons for buying stocks. They first selected a control ! group by picking stocks at random and tracking down their owners. Then they randomly selected stocks with the highest price-earnings multiples and big recent price increases -- prima facie evidence of enthusiasm. Investors who owned those stocks made up the second group. The researchers asked both groups whether they bought the stock after a systematic search for good stocks or for some other reason. In the control group 67% were systematic in their approach to the stock selection, while in the high-P/E group only 25% hunted systematically. The rest confessed to having based their decision primarily on such sources as investment newsletters, word-of-mouth recommendations, or gossip about the picks of other money managers. Individual investors can be just as rash. In another study Shiller and Pound polled people who had bought a hot-selling stock in a company that furnished stockholders' names on condition that it not be identified. More than 70% of these investors, the Yale economists learned, bought the stock without studying financial data or reading security analysts' reports. All these findings suggest that what Shiller calls ''contagious enthusiasm'' can draw even the pros into dubious investments. Only through conscious effort can investors try to overcome such emotions, as well as the frailties uncovered by Kahneman and Tversky. The willpower required is considerable, but so are the potential gains.