Fear, greed and the madness of markets: the decisions investors make.

"I can calculate the motions of heavenly bodies, but not the madness of people," Sir Isaac Newton wrote in 1721. His words were as much a lament as an acknowledgment of his own limitations: Newton was one of many investors who had lost their shirts in the "South Sea Bubble."

The American Heritage dictionary defines financial bubble as a "speculative scheme that comes to nothing." The term hadn't even been coined in 1711 when the British government granted the South Sea Co. a monopoly on trade with South America and the Pacific islands. It was a time of unfettered optimism, and all Sir Isaac and others knew was that there were easy fortunes to be made by investing in the new venture. (Sound familiar?) "Men were no longer satisfied with the slow but sure profits of cautious industry," Charles Mackay wrote in his 1841 book, Extraordinary Popular Delusions and the Madness of Crowds. "The hope of boundless wealth for the morrow made them heedless and extravagant for today."

In Newton's case, share prices soared and investors grew rich overnight--on paper. Several company directors dumped their holdings, triggering a panic sell-off and sending stock values to zero. The bubble taught a lesson that, nearly three centuries later, many otherwise sensible individuals have yet to absorb: Financial markets are neither rational nor efficient, and any investment strategy that ignores that fact is doomed to failure. Share prices move up and down according to a bewildering array of factors, only some of which are readily quantifiable or even conventionally discernible by CPAs and the clients they represent. A company's market share, revenue and balance sheet all are key elements. But at least equally important are the vagaries of human psychology and behavior, the conscious and unconscious wishes, conflicts, fears and fantasies that lure people en masse into bad--sometimes catastrophic--decisions.

This article seeks to help CPAs better understand the often confusing market conditions that exist today by looking at the impact human behavior can have on investors and the decisions they make.

FLOCKING TO A DOOMED HYBRID

A recent and especially egregious demonstration of the madness of the markets was AOL's 2001 ill-conceived acquisition of Time Warner, widely touted as the ultimate convergence of new and old media. Investors who should have known better flocked to the new hybrid. At the time, the two companies had a combined market value of $290 billion. Since then, AOL Time Warner's market capitalization has withered to $4 million; the company's $54 billion writeoff in April 2002 was the biggest quarterly loss ever. Whatever motive investors may have had for throwing in their lot with such an unworkable enterprise, it certainly wasn't rational. "Psychology has a story to tell about investing," notes 2002 Nobel laureate Daniel Kahneman, "and it is different from the one economics tells."

In a perfect world, investors would consider all available information before making a buy or sell decision. They should not let emotions or repressed desires--theirs or the market's--enter into their thinking. In such a world, bubbles would never happen. The problem, of course, is that investing never is a purely left-brain activity. Individual and group psychology always has been a critical, if widely overlooked, driver of financial activity. We see things not as they are, but as we want them to be--or as we fear they will become. Or, just as irrationally, we assume things will always remain just as they are and that whatever the market is doing it will continue to do in perpetuity.

Is this what happens in an efficient marketplace? No such thing exists, says economist Peter Bernstein in Against the God: The Remarkable Story of Risk (John Wiley & Sons, 1996). Even a cursory view of financial activity "reveals repeated patterns of irrationality, inconsistency and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty."

It stands to reason: A prolonged downturn is likely to breed fear, which in turn triggers irrational behavior and panic selling at a time when the wisest option might be to stay the course. That's what happened when the stock market crashed on October 19, 1987. A few days later, Yale economist Robert Shiller asked some 900 investors how they accounted for the plunge. Only a third cited economic causes; two-thirds cited psychology. Shiller's conclusion: As news of declining prices spread, panic ensued, accelerating the sell-off and forcing prices lower.

FEAR WEARS MANY FACES

CPAs will find that irrational fear takes other, less obvious, forms as well. Some investors view a short-term loss as an affront to their ego--or, perhaps, a painful reminder of an impoverished childhood. CPAs can render an invaluable service to such clients by suggesting that an irrational avoidance of risk at all costs, to the point of selling winning stocks prematurely, can be the biggest risk of all.

Other investors are driven to make unwise choices because they don't want to be left out or separated from the herd. Again, the CPA can help get them back on course by stating an obvious but often overlooked truth--namely, that there is no profit in following the herd when the herd is chasing glitzy tech stocks with sky-high price-earnings multiples.

The herd instinct was a prime factor in the 2000 to 2001 "tech wreck," the 1929 stock market crash and the Mexican currency crises of 1982 and 1984. True, running with the herd can exact a heavy financial price, but it offers psychic comforts: If the stock goes sour, investors can take comfort in being part of a community of losers. They may likewise seek guidance and approval from a charismatic figure--a Wall Street oracle, Alan Greenspan, the president of the United States or Uncle Phil. Following a three-day dip in the Dow Jones industrial average, Warren Buffett said it was a good time to buy stocks. Is it any surprise the next day, buyers prevailed and the Dow went up?

Consider, too, the behavior known as "fear of regret": You buy a stock, the price falls, and common sense tells you to acknowledge the error and cut your losses. But by selling the stock for less than you paid for it, you not only will incur a net loss, you also will have to deal with the disappointment and embarrassment of having made an unwise investment. To stave off regret and preserve your fragile self-esteem, you hang on and watch the price fall further.

This isn't to dispute the value of well-founded caution and even apprehension when it comes to investing. An "up" market, such as the one we saw in the latter half of the 1990s, can foster a kind of druggy exuberance, inducing investors to sink their life savings into unprofitable companies, bidding up the price beyond all reason. Caught up in the frenzy, others fight for a chance to pay those prices, which, like Newton's apple, have no place to go but down.

Thus, CPAs will find that a measure of rational fear often is needed to put a brake on the kind of runaway optimism--an inflated confidence in one's power and abilities--that can derail an investment strategy. You see it time and again: An investor buys a stock at $10 per share, the value goes to $100, and she congratulates herself for being a financial genius. But she's not. Rather she's just lucky. "The amount of luck as opposed to skill is incredible, yet most people attribute their performance to skill, not luck" says Hersh Shefrin, author of Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing. "It's not quite a random walk down Wall Street, but it is pretty close to it."

BEATING WALL STREET AND OTHER MYTHS

The clinical term for inflated confidence is "grandiosity," and anyone who is convinced he or she can pick stocks, allocate investments and move in and out of positions so as to outperform Wall Street has it in spades.

The strategy almost never works. And it underscores another fundamental axiom too often lost on investors: You can't beat Wall Street. CPAs often can spot that kind of compulsive trading a mile away. In a misguided attempt to maximize returns, a grandiose investor sells a stock as soon as its value has increased, buys another and repeats the process--sell, buy, sell, buy. When you see a client slipping into that pattern, call him on it. Point out that the securities markets are designed to take your money, not add to it, and that they do so by giving you the notion you have more control over your investments than you do.

Indeed, that canard is the industry's most important product, and it has sold well. The truth is, all an investor can do is protect and build on his or her wealth and ensure it will be there when they need it--the paramount objective of any long-term investment program. When a colleague of mine sold his business to a Fortune 1000 company a few years ago, he was offered a choice: all cash or a 20% premium over the cash price if he took the proceeds in stock. He took the cash; he said he "wasn't smart enough" for the stock. It proved a good move. The price of the company's stock rose steadily after the deal closed ... and then abruptly fell. "I may have missed the banquet," he told me, "but I also missed the funeral."

Of course, Wall Street would have us believe we're all smart enough to win big in the stock market. Advertisements for discount brokers and online trading services appeal to the inner overachiever in all of us. They foster the belief that all it takes is a modem and a sheaf of research reports and you're ready to go up against the massed armies of Alexander the Great. In a commercial for one well-known brokerage firm, a retiree sits in front of a computer screen in the comfort of his well-appointed den, smiling contentedly as he checks his portfolio. By astutely picking the right stocks, he has mastered his fate and secured his family's future--or so we are led to believe.

What no ad ever mentions is that you can do everything right--pick the correct stocks, read the best research reports, apply the right criteria--and still wind up in the red. As Modern Portfolio Theory teaches, financial markets are by their nature unpredictable. A company's performance and the price of its stock are influenced by a vast array of events that cannot be foreseen or controlled--currency implosions, changing consumer tastes, technological advances, political turmoil, terrorist attacks and natural disasters, to name just a handful.

FICTITIOUS COMFORT

It's no small wonder the cardigan-garbed retiree in the Wall Street commercial actually is in serious trouble. His stocks are tanking, and the value of his assets is eroding by the hour. Convinced of his own invincibility, he has bought into what Yale University behavioral neuroscientist Jonathan Gewirtz calls Wall Street's "comfortable fictions."

Belief in one's abilities is admirable, Gewirtz concedes, "but why should anyone `believe' in the market? The fact is the market lacks intent--kindly or malign. It is neither orderly nor predictable. To say you believe in the market is like a sailor saying he believes in the ocean. Would you hire such a person to captain your ship?"

Yet people do it all the time. At cocktail receptions, dinner parties, business conferences, in restaurants and airport lounges, people swap tips about which companies to buy and which to shun. "I just read a fascinating article in Barron's about XYZ Co.," says one. "It has a breakthrough cancer drug that should win FDA approval by next year, and no one knows about it. The shares will go through the roof." Or someone else says: "My broker's put me into Czech energy stocks. It's the next hot sector."

To be sure, as many CPAs have found, trolling the Internet for information about a company is easy. Finding useful information is another thing entirely. As economist Frank Knight noted, "Because the economic environment is constantly changing, all economic data are specific to their own time period, and consequently they provide only frail data for generalizations." People talk as if the information on which they're trading could possibly be authoritative and coming to them in real time. What they fail to realize is the information already has been widely disseminated, worked over and devalued, and that the smart money already has profited. "They think they've come into the game at the beginning," says a friend of mine who plays tournament chess, "but they're only a move away from being checkmated."

Most laypersons are not capable of making sense out of the information they collect nor do they know what to do with it. "I've analyzed its financial statements," people will tell me. "The company looks to be in good shape." Are they serious? A typical corporate financial statement is about as decipherable as a computer manual written in Apache. The rules governing its preparation are so arcane and the language so dense even highly sophisticated investors are hard-pressed to understand what they're reading.

YOU CAN'T WIN, ONLY NOT LOSE

Perhaps the most useful investment advice a CPA can offer a client is: "Know thyself." Investing smart requires a clear understanding of your values and life goals--what you hope to achieve by investing. Do you see investing as a game of chance or a means of preserving your assets and growing them over time? Do you understand the difference between selling prematurely and quitting while you're ahead? Are you able to keep your fears, greed and grandiosity at bay when making investment decisions?

It's essential for CPAs to encourage clients to ask themselves these questions. You cannot expect to keep emotions from clouding your judgment if you aren't conscious of them. But self-awareness is only half the picture. As John von Neumann observed in setting forth his theory of games in 1944, the value of one's holdings is largely determined by the intentions of others. Those intentions defy prediction and the individual who tries to do so is doomed to lose.

To avoid this trap, smart investors rely on investment professionals who are highly knowledgeable about behavioral finance--a discipline that carefully analyzes how individual and group psychology influences investor behavior and market trends. Admittedly, few nonprofessionals have the time, inclination or psychological self-awareness to master and apply the principles of behavioral finance. But CPAs should heed this advice: No investment strategy, no matter how solidly based on quantitative reality and market fundamentals, is complete without them.

As Freud taught, nine-tenths of people's lives take place "below the surface." But that terra incognita becomes visible if you know where--and how--to look. No doubt Freud would have taken issue with Newton's complaint. Just as it is possible to analyze the human psyche, it is possible to calculate the madness of the financial markets--and, more important, to minimize its impact on your portfolio. As many CPAs already know, all it takes is the right adviser--and the right tools.

Historic Speculative "Bubbles"

Dutch Tulipmania

1634 to 1638

France's Mississippi Bubble

1719 to 1720

South Sea Bubble

1720

Roaring '20s U.S. Bull Market

1924 to 1929

Japan's "Bubble Economy"

1984 to 1989

EXECUTIVE SUMMARY

* HISTORY SHOWS THAT FINANCIAL MARKETS ARE NEITHER rational nor efficient, and any investment strategy that ignores that fact is doomed to failure. Stock prices move up and down according to a bewildering array of factors, only some of which are easily apparent to CPAs and the clients they advise.

* IN A PERFECT WORLD, INVESTORS WOULD CONSIDER all available information before deciding to buy or sell a stock. In reality, however, individual and group psychology is a critical and often overlooked driver of financial activity.

* A PROLONGED MARKED DOWNTURN CAN BREED FEAR, which in turn triggers irrational investor behavior and panic selling. The herd instinct was a prime factor in a number of financial disasters, most recently the 2000 to 2001 "tech wreck." Despite the comforts it may offer, running with the herd can exact a heavy financial price.

* THE PARAMOUNT OBJECTIVE OF ANY LONG-TERM investment program CPAs recommend should be to protect and build wealth thus ensuring it will be there when the client needs it. Those who set out to beat Wall Street will usually be disappointed.

* THE BEST WAY CLIENTS CAN KEEP EMOTIONS FROM clouding their judgment is to be aware of them. Smart investors rely on advisers who understand behavioral finance and are able to analyze how individual and group behavior influence market trends.

WILLIAM LANDBERG, CPA, is a managing member of West End Financial Advisors, LLC, in White Plains, New York. His email address is [e-mail].