SPEED IS OF THE ESSENCE (NOT)
The socialization of investing has created an environment where you think you must move quickly in your decision making. If you watch the financial and business news cable channels, you have been bombarded with commercials suggesting that, in investing, the slow die first. You need the fastest Internet provider so you can subscribe to the fastest news provider and trade on the fastest online brokerage system. For a while, CNBC even perpetuated this idea by timing and reporting the responsiveness of the major online brokerages.
Making split-second decisions after news reports in order to move with (or even beat) the herd is not investing. It is trading. Trading is like gambling in that it fosters strong emotional responses. We will explore this in a later chapter that focuses on Internet investors. Unfortunately, this need for speed magnifies your psychological biases.
Consider the simple mistakes that occur when people make split-second decisions. On April 11, 1997, a Financial Times story reported that the Czech Value Fund had invested in fraudulent companies and was facing big losses.3 When the news reached the United States, the stock with ticker symbol CVF fell by 32% on high volume. The problem was that CVF is the ticker for the Castle Convertible Fund, not the Czech Value Fund. By the end of the day Castle had mostly recovered, but that didn't help the investors who sold at the bottom. This is an example of how other investors' errors can cause you problems.
On June 24,1998, the media reported that AT&T had agreed to purchase Tele-Communications Inc. for $45.8 billion. On that news, the stock with ticker symbol TCI jumped nearly 5% on volume that was more than 37 times the norm for the firm.4 But TCI
When vou are moving with the hertl vou is the tickDer , fo\ Trans get caught up in the emotions of the continental Invest OTS to 1C1 live years earlier when Bell Atlantic Corp. announced its intention to buy Tele-Communications.
This case of mistaken identity occurred repeatedly over a one-year period with people trying to buy MCI Communications in response to a string of takeover rumors. They bought MCI, which is actually the ticker for Massmutual Corporate Investors, a closed-end fund on the New York Stock Exchange. The ticker for MCI Communications is MCIC.
These errors are due to speed. If you buy the wrong stock when it is inflated by investors herding in error, you will lose money. Your emotional high is followed by an emotional and financial low.
INVESTMENT CLUBS
One example of how investing has been socialized is the rapid growth of investment clubs. Investment clubs may consist of family members, friends, or coworkers, for example—frequently all men or all women—who band together to pool their money and invest it in the stock market. These groups typically meet once a month and discuss potential stock investments. Every month the members each contribute some nominal amount ($20 to $100), which is pooled together and invested.
The creation of investment clubs is fostered through the National Association of Investors Corp. (NAIC). Although not all clubs are members of the NAIC, the organization boasted 35,810 clubs and 537,150 total members at the end of 2000. This is a substantial increase from the 7,087 clubs registered in 1990.
Some of this increased popularity comes from the socialization of investing in our culture. Since you discuss your stock picks with your coworker, your family, and your neighbor, it is only natural to form more formal investing groups. However, some of the increased popularity of investment clubs probably comes from the fame of the Beardstown Ladies.
Beardstown Ladies
The Beardstown Ladies is an investment club made up of 14 ladies from Beardstown, Illinois. The ladies, who average 70 years old, became famous when they reported an annual return of 23.4% over a 10-year period. This is outstanding considering the Dow Jones Industrial Average returned 12.1% during the same period. The idea that these adorable ladies could have returned nearly double the return of the market and most mutual funds during this 10-year period gave investors everywhere hope. The ladies became celebrities. They wrote five books on money management, starred in a video, and were invited to give investment speeches all over the country.
Then the famous Beardstown Ladies became infamous. A Price Waterhouse audit reported that their 23.4% annual return was really 9.1%. The ladies actually substantially underperformed the market and most mutual funds. It turns out that they misunderstood the portfolio-tracking software they were using. The higher return seems to have been caused by including new contributions to the portfolio as if they were profits.
Investment Club Performance
The Beardstown Ladies aside, how do most investment clubs perform? The financial press has made frequent claims suggesting that anywhere from 60% to 67% of the investment clubs are beating the market. If true, this figure would also be impressive given that most mutual funds don't routinely beat the market.
However, it is unlikely that these figures accurately reflect the performance of most investment clubs. The claims come from annual surveys of clubs by the NAIC. Consider the problems with this type of survey. First, the clubs have to properly calculate their annualized return. The Beardstown Ladies example shows that this is not necessarily easy. Second, which clubs respond to the survey? If you were the treasurer of a club, when would you respond to a survey by the NAIC? I'll bet you would be far more likely to fill out the survey if your club's returns were very high and avoid filling out the survey if the returns were low. The psychological biases of seeking pride and avoiding regret suggest this behavior (see Chapter 5). Indeed, only 5-10% of the clubs return the NAIC survey. It is very likely that these are the clubs that calculated (hopefully correctly) a high return. Therefore, the survey results represent only the more successful clubs (at best) and are probably totally misrepresentative of all clubs (at worst).
To get a more objective view of investment club performance, the actual stock holdings of 166 investment clubs using a national discount broker were examined over a five-year period.5 As Figure 7.2 shows, the results are not good. During the period, the S&P 500 index earned an average 18% return annually, but the clubs averaged a gross return of only 17% per year. The return net of expenses was only 14.1%. The clubs substantially underperformed the market. Whereas media reports suggest that more than 60% of the clubs beat the market, it appears that 60% actually underperform the market. Indeed, it appears the same psychological biases are at work in the investing behavior of these clubs as we have discussed in individual investing. Specifically, trading behavior is consistent with overconfidence (Chapters 2 and 3) and the disposition effect (Chapter 5).
Investment Clubs and Social Dynamics
Although an investment club's purpose is to create an environment for learning about investing and achieving good returns, most clubs also serve a social purpose. The meetings themselves provide a vehicle for family or friends to regularly meet and socialize. Members like the idea of sharing research skills and knowledge about the market while socializing.
The social dynamics of the club play an important role in its investment success. Some clubs take their stock picking very seriously. For example, the Klondike Investment Club of Buffalo, Wyoming, was rated the number one investment club in America one year by Value Line.6 The 18 members of the club come from all walks of life. Some are young and some are old. Some are blue-collar workers and some are white-collar workers. Some have advanced degrees, while others are business owners. So what is their secret to success? The Klondikers require all investment decisions to be made with the help of a rigorous report produced by the sponsoring member. They rely on research, not just stories about a firm. This is important because the approach helps to avoid some psychological biases. Their decisions are based more on reason and logic than emotion.
Other investment clubs view the social aspects of the club to be the primary objective. Consider the California Investors club founded by a group of retired friends who worked together for many years. Investment decisions are often made without much analysis.7 Discussions often center on hot tips and speculations. Thus, the club frequently buys at the top and later sells at the bottom and, as a consequence, has earned a poor return. Alternatively, the social events like the Christmas party and a day-long golf outing are planned in biases to combine with those of other members and thus be magnified. The social aspects of the club are more important than the economic aspects.
SUMMING UP
Section 2 of this book has illustrated how your emotions affect your buy/sell decisions and how you react to winning and losing. I end this section with this chapter because socializing is based on emotional needs. Your natural need to talk to others combines with your interest in investing. When this occurs across a society, we see the socialization of investing.
The next section of the book discusses how your brain functions. Your brain does not work like a computer. You don't process information or remember things like a computer. Sometimes, this can be a problem.
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