Investors who can stay aboard market's wild ride could be headed for big gains
| New York
White-knuckle days? During 10 of the last 11 trading sessions, the Dow Jones industrials average has swung, sometimes abruptly, up and down at least 48 points. In four trading sessions before the Good Friday holiday last week, the Dow lost 62.79 points to close at 2275.99.
It looks like a wild, roller coaster of a market, a tricky place for investors. Prudence dictates a sideline position until things settle down.
That may be the perception. The facts indicate otherwise.
Yes, the point swings are bigger. But on a percentage basis ``there's been a slight, just a slight, pickup in intra-day volatility,'' says Laszlo Birinyi, head equity trader for Salomon Brothers. ``But on a close-to-close basis, volatility is no greater.''
In fact, since this bull market began in 1982 there's been a general decline in intra-day price swings, he says.
It's one small example of a widely-held market misperception. Similar superficial conclusions are drawn and acted upon daily. And both amateur and professional investors tend to be susceptible.
Indeed, despite a well-proven record that strategies of contrarian actions are most profitable, investors continue to make mistakes en masse.
Several academic studies illustrate the point.
Cornell University economist Richard Thaler and University of Wisconsin finance professor Werner De Bondt have delved into the performance characteristics of Wall Street's dogs and dandies.
In the Journal of Finance in 1985, they reported that during the last 50 years, stocks dropping the most in price over a three-to-five year period turn around and provide the biggest gains, on average, for the next three to five years. Conversely, the top performers during a similar time frame later become laggards.
A strategy built on this information produces extraordinary gains.
``If you bought a pool of the biggest losers of the last three years and sold short the biggest winners, the portfolio return over the next three years would be 8 percent above the market,'' says Professor De Bondt. And if only the worst dogs were bought a 5 percent return above the market would result, he says.
De Bondt's explanation: ``For the big winners, people are way too optimistic about earnings'' and abruptly sell their holdings when the overvaluation is recognized. Conversely, people are way too pessimistic about companies with a poor earnings trend and end up buying the stock as earnings rebound.
When it first came out, this study was attacked by the efficient-market theorists at the University of Chicago. There are still doubters. But the results have been replicated by other researchers. And in the July 1987 Journal of Finance, Thaler and De Bondt will defend their study.
Along similar lines, finance professors Meir Statman and Hersh M. Shefrin at Santa Clara University are studing the stock performance of those companies voted most, and least, admired by brokerage firm research analysts surveyed each year by Fortune magazine.
Preliminary findings suggest an investment ``concentrated in the least-admired stocks will do better than one in the most admired,'' says Professor Statman.
None of this may come as particularly startling news to readers of Benjamin Graham. Thirty-three years ago, in his classic market treatise, ``The Intelligent Investor,'' he observed that misvalued stocks should take about 2 years to become correctly valued.
Yet, ``if it is not news - that bad companies make good stocks - why doesn't this effect disappear?'' Statman asks. ``Because many people talk about themselves as contrarians. We all like to see ourselves as mavericks. But when you ask them about their portfolios, they're anything but contrarian.''
Why? ``Psychologically, it's a strain. Who wants to own a Bank of America, a Pan Am, or a Navistar? And realistically, some of these [loser] stocks will go out of business,'' says Professor De Bondt.
De Bondt points to recent studies into the dynamics of the human decision-making process by psychology professors Daniel Kahneman of the University of California at Berkeley and Amos Tversky of Stanford University.
Tests by these two professors appear to show that people have a great fear of loss. That fear often causes people to disregard probablities and proven facts. It prevents them from buying a lousy-looking company even though statistically it has been shown that bad companies make good investments.
Another concern - fear of regret - can skew judgment too, says Statman. This fear also can be described as berating oneself mentally after making a ``poor'' decision. But these finance psychologists contend investors kick themselves only when it applies to an unpopular choice.
``If IBM's stock drops, you'll look at the misfortune as an act of God,'' wrote Statman in Psychology Today in February 1986. And you've taken comfort knowing many others share your misfortune. But choosing a less-admired stock carries more responsibility and a higher potential for regret. ``If you buy Continental Illinois and it goes down in price, you'll blame yourself.''
Yet the rewards are there, too. When the Latin American debt crisis hit the headlines back in 1984, pessimism caused bank stocks to plunge. Manufacturers Hanover fell from around $41 to $22. By the end of the year, it had rebounded to $39. Could today's Brazilian debt crisis produce a similar pattern in bank stocks?
Again, Wall Street inherently knows most of this. Thaler at Cornell notes that ``loser'' stocks are characterized by low price/earnings ratios (p/e's) and low market-to-book-value ratios. Both are relatively common stock selection tools.
But few firms can resist doing ``value-added'' research or can stick to a strategy in the face of ``bad'' news. ``It takes a lot of guts to employ this as a sole strategy,'' says Thaler.
Brandywine Asset Management in Wilmington, Del., is one of the few investment firms that uses low p/e's as its sole selection tool. The firm buys only those companies that have a p/e in the bottom 20 percent of the overall market.
Brandywine draws support from a study by University of Pennsylvania's Wharton School. It shows stocks in this bottom group historically produce average annual returns 2 to 9.6 precent better than higher p/e stocks. Founded in 1986, the Brandywine portfolio has kept pace with the market.
But the academics' evidence suggests that if Brandywine sticks to its strategy over the long haul it should outperform the market.