Don't look for logic in the way investors act, say these experts.

Over the last two years, investor sentiment has ricocheted from gloomy to euphoric. Yet amid the optimism, some nagging questions remain. Why are investors enamored with the same high-flying stocks that crashed just two years ago? How will investor sentiment impact the stock market? How should financial advisors address the escalated client expectations that often come with a bull market?

Behavioral finance experts say that to a great extent, the answers to those questions lie in an understanding that mental mistakes and irrational behavior, rather than calculated logic, dominate investor thinking. Traits such as overconfidence, excessive optimism, the tendency to believe that the recent past predicts the future and even the need to keep up with the neighbors are powerful forces that drive investor response and, ultimately, the direction of stock prices.

Below, three leading experts in this emerging field talk about how financial advisors can use their findings to understand some of the forces in today's investors, devise investment strategies that capitalize on irrational human behavior and improve client relationships.

David Dreman

Chairman, Dreman Value Management

Advice: Beware of bubble stocks

"Many of the same stocks that led the last overheated bull market and later bombed are the same ones that have led the recent rally," says noted money manager David Dreman. "That has never happened before in financial history."

Financial history and the forces behind it are more than just a passing interest to Dreman. Since the late 1970s, he has written four books on contrarian investing and the psychology of the stock market. He serves as co-editor of an academic journal, "The Journal Of Behavioral Finance." His firm puts behavioral finance theory into practice by managing institutional money, as well as four funds under the Scudder-Dreman label.

Yet with all that experience behind him, Dreman admits that the enormous surge in speculative stocks last year caught him off guard. He attributes much of it to a new term in behavioral finance called "the affect heuristic."

In a nutshell, the affect heuristic says that the more people like something, the more they will continue to think of it in positive terms. If they like something enough, price will become irrelevant and emotions, rather than logical thinking, will dominate their actions. This behavior, which surfaces among professional investors as well as individuals, helps explain why stocks like Cisco, Dell, Yahoo and Juniper Networks are able to command stratospheric price-earnings multiples.

Dreman says that while he doesn't know when the bubble will burst, he believes the market will "stay closer to fundamentals this year, which means overall gains in the 10% to 15% range at best." With the memory of the tech bust just a little over two years old, investors may not have the same level of blind faith as they had in 1999, he says.

The affect heuristic also applies to value stocks, but as a mirror image to its growth stock application. "The more we dislike a person or idea, the more likely we are to place a low value on it," he says. "The same principle applies when people flee en masse from value stocks."

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