Psychological research has shown that the brain uses shortcuts to reduce the complexity of analyzing information. These shortcuts allow the brain to generate an estimate of the answer before fully digesting all the available information. Two examples of shortcuts are known as representativeness and familiarity. Using these shortcuts allows the brain to organize and quickly process large amounts of information. However, these shortcuts also make it hard for investors to correctly analyze new information and can lead to inaccurate conclusions.

REPRESENTATIVENESS

The brain makes the assumption that things that share simi­lar qualities are quite alike. Representativeness is judgment based on stereotypes. Consider the following question:

Mary is quiet, studious, and very concerned with social issues. While an undergraduate at Berkeley, she majored in English literature and environmental studies.

Based on this information, which of the following three cases is most probable?

A.   Mary is a librarian.

B.   Mary is a librarian and a member of the Sierra
Club.

C.   Mary works in the banking industry.

Which answer do you think is most probable? I pose this question to undergraduate investment students, MBA stu­dents, and financial advisors. In all three groups, over half the subjects choose answer B—Mary is a librarian and a member of the Sierra Club. People select this answer because being a librarian and a member of the Sierra Club is representative of the type of career a studious person con­cerned with social issues might pick. However, the question asked which answer is most probable, not which scenario would make Mary the happiest (see also about money investment).

Answer A—Mary is a librarian—is a superior answer to B. Being a librarian and a Sierra Club member is also being a librarian—that is, answer B is a subset of answer A. Because answer A includes part of answer B, it is more probable that case A is true. A quarter to a third of the subjects asked usually understand this and choose answer A over answer B.

However, the best answer is actually C—Mary works in the banking industry. There are many more people employed by banks than by libraries. If fact, there are so many more jobs in banking that it is far more probable that Mary works in the banking industry than as a librarian. Because working in the banking industry is not repre­sentative of the shortcut our brain makes to describe Mary, very few people pick answer C.

Representativeness and Investing

A good company is not necessarily a good investment. Investors tend to think one equals the other. People also make representativeness errors in financial markets. For example, investors often confuse a good company with a good investment. Good companies are those that generate strong earnings and have high sales growth and quality management. Good investments are stocks that increase in price more than other stocks. Are the stocks of good companies good investments? The answer may be no.1

Classifying good stocks as stocks in companies with a history of consistent earnings growth ignores the fact that few companies can sustain the high levels of growth achieved in the past. Nevertheless, the popularity of these firms drives their stock prices even higher. Eventually it becomes apparent that investors have been too opti­mistic in predicting future growth, and the stock price falls. This is known as overreaction (see also about where to invest).

Consider the performance of stocks typically considered by investors to be growth stocks. Since investors like these companies, we'll call growth stocks glamor. And we'll use the term value stocks to denote the companies that investors typically consider to be less desirable with minimal growth prospects. Investors consider growth companies to be firms with growing business operations. The aver­age growth rate in sales for all companies over the past five years is a good measure of business growth. The 10% of companies with the highest average growth rates are glamor firms, while the companies with the lowest sales growth are value firms. Glamor or value, which stocks are better investments over the next 12 months? The next five years?

One study uses data for all stocks on both the New York Stock Exchange and the American Stock Exchange over the period 1963-90. The results are shown in Figure ll.l.2 Say that you identify the glamor stocks in 1963. You buy these stocks and hold them for one year. In 1964, you also identify the glamor stocks. You buy and hold these for one year. By 1990, your glamor stocks investing strategy earned you an average 11.4% return per year. This compares to an average return of 18.7% for a value stock investing strategy. The average total return over a five-year holding period was 81.8% for the glamor stocks and 143.4% for the value stocks. Another popular measure of glamor/value stocks is the price/earnings (P/E) ratio. Companies with high P/E ratios are more glamorous than firms with low P/E ratios. Figure 11.1 also demonstrates that value stocks outperform glamor stocks when the P/E ratio is used to measure performance (see also about intellectual capital).

Here is a stock that might interest you—a technology firm that has increased sales by more than 20% per year in the past couple of years and has increased earnings per share by over 35% in each of the past two years. This well-known growth company is no small business—it's Compaq Computer Corp. For the year 2000, Compaq had over $24 billion in revenue and nearly $2 billion in profits. In late 1998 Compaq sounded very glamorous. Indeed, during the three years prior to 1998 the firm's stock had risen 338%. In January of 1999, Compaq stock rose 17% more to $49.25 a share. That was the peak for Compaq. One month later the price was $35 a share. Three months later it was $24. The price eventually fell to less than $20 a share. All this in 1999, the year that may have been the best ever for technology firms.

Good companies do not always make good investments! Investors make the mistake of believing they do because they believe that the past operating performance of a company is representative of its future performance and they ignore information that does not fit into this notion. Good companies do not perform well forever, just as bad companies do not perform poorly forever.

You can make a similar error when examining past stock returns. For example, a stock that has performed badly for the past three to five years is considered a loser. Stocks that have done well for the past three to five years are winners. You may consider this past return to be representative of what you can expect in the future. In general, investors like to chase the winners and buy stocks that have trended upwards in price. However, the losers tend to outperform the win­ners over the next three years by 30%!3 Mutual fund investors also make this error. The mutual funds listed in magazines and newspa­pers with the highest recent performance experience a flood of new investors. These investors are chasing the winners.

In short, you interpret the past business operations of a com­pany and the past performance of its stock as representative of future expectations. Unfortunately, businesses tend to revert to the mean over the long term. Fast-growing firms find that competition increases, slowing their rate of growth. Disappointed, you find that the stock does not perform as expected.