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Irrational Pessimism
Hurley and Fuller, December 2001

The phone rang in Kathy Boyle's office one Friday evening in September. The voice on the other end was familiar. But it was not friendly: "I pay you to give me advice. Now give me some advice."

Frantic and panicked after the worst week in Wall Street history, the voice needed more than an eager ear to shout at. It demanded action. After 30 minutes, the client, an unemployed owner of a house in the Hamptons and a penthouse in New York City still trying to finance helicopter lessons from last summer, instructed Boyle to sell a substantial portion of her client's portfolio.

"I think the layoffs are starting to hit a little closer to home," said Boyle, president of Boston-based Chapin Hill Advisors. "Stores are closed. The market has now been bad for a year and a half and it's just starting to get uglier. Some clients are paralyzed. They're refusing to invest. They have a lack of reality."

The example is an extreme case of a client stretched too thin by unrealistic expectations and unfortunate circumstance. But most advisors have clients in similar situations as a result of the market meltdown. In the 18 months ended August 31, 2001, the Nasdaq was down 61.1 percent, the EAFE (Europe, Australia, Far East) 27.1 percent, the Russell 2000 17.3 percent and the S&P 500 15.5 percent. Then September 2001 was even worse. Unemployment is up. Consumer confidence is down. And more clients are seriously struggling to resist the urge to go to cash.

In early 2000, Professor Robert Shiller of Yale University published Irrational Exuberance, a book that speculated that a fall in the market was imminent. Valuations were crazy. Fundamentals were ignored. Stocks had to come down in a big way, he said - and they subsequently did. As we near the end of 2001, the pendulum has swung to the opposite extreme.


Cognitive psychologists use the term "saliency" to refer to how the human brain reacts to extremely traumatic events. The more traumatic and more recent the event, the greater the human brain assumes its probability of recurring, regardless of the actual probability of a similar event. The brain simply chooses to ignore other factors that might affect a particular event or circumstance.

From a financial markets perspective, saliency is one of the core sources of value investing. Companies that have exceptionally poor results for a long period of time are often mentally written off by investors. They even ignore potential positive signals - such as improving fundamentals or even senior management increasing their personal holdings of company stock - and artificially depress the company's stock price. Famous investors such as Michael Price and Warren Buffett seek out these companies that other investors give up on prematurely.

Saliency is not limited only to individual stocks. The prolonged trauma of a market meltdown over the last 19 months has caused many investors to give up on the stock market in general, placing all of their investable assets in cash.

Clearly the events of September 11 have traumatized the nation and have had extremely negative effects on the financial markets. And no one can say with any certainty what the financial markets will do over the next 12 to 18 months.

However, similar moments of crisis in the past have provided lucrative opportunities. As seen in Table 1, the market has bounced back strongly after several previous crises - and there is reason to believe this crisis period offers similar potential. The Federal Reserve is currently flooding the economy. Liquidity and interest rates are at a 29-year low. And the government is preparing to launch a massive fiscal stimulus to jump-start the economy.

The challenge for advisors is to convince investors to ignore instinct and remain rational after 19 months of financial trauma.

"My clients are concerned," said Kelly Auslander, president of American Financial Advisors in New York. "I think this is going to be a painful rise upward. I'm personally not expecting anything to happen until 2002. But when you see an opportunity that stock prices are extremely low, that is the time to get in the market."

While no one can precisely predict when the market will bottom out, one thing is certain - attempting to time the market can be disastrous. Missing only a few days in any market rally can cost investors a substantial part of their potential return. From May 1992 to April 1993, shortly after the conclusion of the Gulf War, the Dow Jones was up 5 percent, but if you missed the best five days, the return was - 10 percent. Similarly, the year after the Korean War, the market was up 10 percent, but if you missed the five best days, the return was 0 percent.

Facts like these, combined with the historical market performance in post-crisis periods, help advisors educate their clients. But they don't convince all clients to stick to the plan. Some are taking extreme steps to avoid having their portfolios depleted. They are fearful that they won't have enough money to retire, fearful that they won't be able to maintain their current lifestyle or pay for their children's education. And they are forcing their advisors to put their portfolios completely in cash.

Auslander has two such clients. So does Jayne Byrne of Wayne Warner & Associates in California. In fact, one of Byrne's clients, after acquiring new cash as a result of a recent real estate sale, called on four consecutive late September days to ensure that the money hadn't yet been invested.

This potentially irrational pessimism in effect is a greater challenge to advisory businesses than irrational exuberance. It is a far easier proposition to convince an investor in a booming market to reduce some risk in exchange for less upside than to convince traumatized investors to go against their instincts and remain in the markets - that is, continue to risk already depleted capital in exchange for potential upside. But if they don't, the client may miss most of the upside and will likely have a horrible return that could lead to the advisor being fired.

"You have to take certain levels of risk to meet long-term investment objectives," said Chris Wilkinson, the chief operating officer of Miller/Russell & Associates in Phoenix, Arizona. "But the last few years (before the downturn) the market was so strong that people really didn't understand the inherent risk. Our discussions in meetings are now much more honest in terms of risk. But (with less risk taken) it may be hard to accomplish all the goals of a client, whether it be a second cabin or retirement or whatever."

That said, Wilkinson and his firm, as well as the majority of advisory firms throughout the country, are trying to make sure their clients stay invested in equities, so they don't miss the turn. The scattered extreme examples notwithstanding, most clients aren't complaining too loudly. They are sticking to the plan.

Mark Hurley is president and CEO of Undiscovered Managers, LLC, based in Dallas, Texas.
Tom Fuller is director of research in the Investor Services Group for Undiscovered Managers, LLC.