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ANALYST WATCH: Emotional investing a recipe for disaster

The Nasdaq composite has made a modest recovery from its startling sell-off in 2000 and people are starting to feel good about themselves again. Investors give a lot of lip service to fundamentals and valuations, but the sad truth is emotion drives the market.

It always has and it always will.

After watching the Nasdaq blast through the 5,000-point threshold in March only to give back half its value by year’s end, the average investor was forced to reevaluate his or her expectations and investing philosophy.

What happens on a day-to-day basis on Wall Street goes far beyond the clich?s of greed and fear.

How crazy is it that people who just a year ago couldn’t throw enough money at money-losing ‘Net stocks or even profitable tech firms trading at 500 or 600 times trailing earnings now can’t muster the courage to buy leaders such as Intel (Nasdaq: INTC), Sun Microsystems (Nasdaq: SUNW) or Oracle (Nasdaq: ORCL) at bargain-basement prices today?

Irrational trading

Experienced traders will tell you the overwhelming majority of individual investors will hold on to a losing stock too long and sell a winner far too early.

It doesn’t make sense, but investors do it time and time again.

“People hold losers too long mainly because they make a distinction between a paper loss and a real loss,” said Meir Statman, a behavioral finance professor at Santa Clara University. “The underlying emotion is regret. People don’t want to come to terms with the fact they picked a loser and, in some sense, are a loser themselves.”

Statman, who has published volumes of literature on investor behavior and psychology, said the ebb and flow of trading on Wall Street is a direct reflection of basic human needs.

“Investors get wrapped up in these things,” he said. “People prefer beautiful, rich, smart people. If you pick a good stock you want to tell people about it. And what you’re really telling them is that you’re smart and that you’re rich.”

Typically, investors will sell good stocks early for a profit and then reinvest the money into other stocks. Eventually, the run of luck comes to an end.

“I’ve got tons of stories,” said a trader at major discount brokerage firm. “It’s a gambling addiction. People will sell a stock after it goes up two or three points just to go and buy another stock. What’s the point?”

Sometimes investors get angry when their broker recommends selling their pet stock or, at the very least, diversifying their holdings.

It happens to institutional brokers, too.

You are what you own

Wall Street lore is littered with tales of money managers in years past who fell in love with a Schlumberger (NYSE: SLB) or Digital Equipment, took a disproportionately large position, and then watched the stock head south.

You’d have to look far and wide these days to find a mutual fund that doesn’t include Cisco Systems (Nasdaq: CSCO) or Sun Microsystems (Nasdaq: SUNW) as major holding.

“One of the big problems these days is that a consumer attitude has permeated stock investing,” said Tad LaFountain, an analyst at Needham & Co. “Instead of people saying they are what they eat, they’re now saying they are what they buy.”

From golf courses, to local pubs to family barbeques, more and more people are talking about the stock market and the stocks they own than ever before. An argument could easily be made that the market has replaced the weather as the small talk topic of our time.

“It’s like rooting for a football team,” LaFountain said. “It’s an innate human condition. People are always looking for an emotional shortcut.”

The discount trader, who didn’t want to be identified for obvious reasons, said people who own shares of the companies they work for stick by their stock with a cult-like conviction.

“People who work at Cisco are the worst because they’ve only seen their stock go up, up, up,” he said. “They’re convinced it’s only going to go higher. They hold as much as $5 million or more in Cisco stock and don’t want to consider maybe getting into bonds or at least diversifying a little bit.”

Long-time Cisco shareholders don’t have a whole lot to complain about, but it’s just a matter of time before even this outstanding company loses its luster on the Street.

“A lot of investors and analysts get into trouble when they really like a company or a technology or the management team,” said Sandy Harrison, an analyst at Pacific Growth Equities. “At the end of the day, you have to put aside whatever you think of the company and concentrate only on the potential of the stock.”

Buy and hold for long-term success

To avoid falling prey to your own weaknesses, money managers hammer home the strategy of diversifying your investments throughout a number of industries. A healthy balance of equities, bonds and cash vastly improve your chances of beating the market in the long run.

Most investors will say they agree with that formula before buying the next “can’t-miss” IPO, often on margin.

“That’s the biggest problem,” the trader said. “People get introduced to Mr. Margin and they’re amazed by how much money they can make when the market’s on fire. But, like we saw in December, when those margin calls come, they inevitable end up selling all their stocks at the worst possible time.”

When the market turns sour, trading volume declines as investors who used to sell their winners prematurely to buy their next project now sit in on the sidelines, holding their losers and wondering what could have been.

“I guarantee you there a lot of individual investors as well as portfolio managers who went home for Christmas this year and were just sick,” LaFountain said. “They realized that if they would have just sold their positions in March, they would have made an outstanding amount of money.”

Now that the market’s made such a severe correction, some investors believe now’s the time to buy tech stocks while valuations are, compared to this time last year, relatively tame.

However, Statman said the historical data doesn’t support what he calls this “illusion of validity.”

After tracking the performance of the stock market from 1873 to 1998, Statman discovered that in years that produced above-median returns most of the stocks had relatively high price-to-earnings ratios. Those years that began with low price-to-earnings ratios tended to conclude with lower returns.

He concluded that often there’s a damn good reason why P/E ratios are so high, usually because the economy has improved dramatically and investors hadn’t grasped just how much it had improved. Conversely, if the P/E ratios were lower, it was usually indicative of a slowing economy.

Second-guessing is an unavoidable occupational hazard for traders. But with this wealth of information from the electronic media, real-time quotes and in-depth analysis, why do average investors with so much at stake continue to repeat their mistakes?

“People put themselves at risk for all kinds of reasons,” Statman said. “But trying to convince someone not to do something that’s not very smart is quite difficult. When you’re talking about egos and pride and status, it’s almost impossible to convince someone they’re making a big mistake.”