ACTIVIDADES DE EXTENSIÓN Escuela de verano

This chapter has been about how you view risk. You tend to seek risk or minimize the effects of risk when you have big gains. Alternatively, you tend to avoid risk or overestimate risk after experi- encing big losses. This behavior contributes to stock market bubbles. The value of a stock derives from its ability to earn profits. The profits from existing operations and the growth of profits in the future are directly related to the company’s fundamental value. Companies that generate high profits and growth are valued highly. Of course, future growth is uncertain. Stockholders face the risk of the firm not achieving the expected growth. When companies do not meet expectations, stock prices fall.5

Consider two companies. One is considered to have an excep- tional management team. The other’s management has a terrible rep- utation. Which is riskier for you to own? Did you pick the company with the exceptional management or the one with the terrible man- agement? Most people think that the badly managed company is riskier. However, this is incorrect. Since people expect the well-man- aged company to do well, it must perform exceptionally well just to meet those expectations. If its performance is merely very good, it does not meet expectations and the stock price falls. On the other hand, since everyone expects the badly managed company to perform badly, that expectation is certainly not very hard to meet. However, if the company performs just badly (instead of terribly) then it beats expectations and the stock price rises. Therefore, it is not as risky to invest in the badly managed company as it would be to buy stock in the well-managed company. It is not the level of the expectation that moves stock prices, but rather the failure to achieve those expected profits.

Now let’s consider the dramatic rise of the technology and Internet sectors in the late 1990s. The prices of these stocks were driven to incredibly high valuations. The high valuations of e-busi- nesses like Amazon.com, Inc., eBay, Inc., and eToys, Inc., reflected outlandish expectations. Remember, these high expectations also mean high risk. How do you react in a market like this? After watch- ing these stocks experience some good gains, you feel the house- money effect and jump into the market and buy some of these stocks. You either ignore or discount the risks. Even worse, you see the high returns generated by these companies in the past and extrapolate those returns for the future. You think the risk is lower

because of the high valuations, not higher!

Eventually, the market valuations get too high to be sustained. The bubble pops. When prices plummet, you feel snake bit. Suddenly risk is important to you. In fact, it becomes the most important factor in investing. You do not buy more of these e-busi- nesses. In fact, you want out—these stocks are now too risky to own! The mass exodus out of the stocks drives the prices down, too far in the case of some of the technology and Internet stocks. The expecta- tions of these companies are driven down so low that meeting them should be easy. The risk of these firms is now lower. However, as a snake-bit investor, you overestimate the risk and avoid these stocks.

Of course, you have heard the investment advice, “Buy low, sell high.” Why is this so hard to do in practice? One reason is that the house-money effect causes you to seek riskier investments—it makes you buy stocks that

have already had sub- stantial increases in price. These stocks are risky because expecta-

tions have been elevated too much. In short, you buy high. If stock prices fall, you feel snake bit and you want out, so you sell low. The combination of the house-money and snake-bit effects causes you to do the opposite of buying low and selling high. If many investors behave the same way you do, the entire market can be affected.

INVESTMENT MADNESS:How psychology affects your investing…and what to do about it 63

The psychological bias of seeking (or ignoring) risk of the house-money effect contributes to creating a price bubble. The psychological bias of avoiding risk in the snake-bite effect leads to driving stock prices too low. InvestMadness-06 6/1/01 10:12 AM Page 63

ENDNOTES

1. Page 287 of Daniel Kahneman and Amos Tversky, 1979, “Prospect Theory: An Analysis of Decisions under Risk,”

Econometrica 47(2): 263–91.

2. This discussion is adapted from Richard Thaler and Eric Johnson, 1990, “Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice,” Management Science 36(6): 643–60.

3. Tracey Longo, 2000, “Stupid Investor Tricks,” Financial

Planning, April: 116.

4. Daniel Kahneman and Amos Tversky, 1979, “Prospect Theory: An Analysis of Decisions under Risk,” Econometrica 47(2): 263–91.

5. Aswath Damodaran, 2000, “The Technology Meltdown: Lessons Learned and Unlearned,” New York University working paper.

CHAPTER