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."

Dreman says that the fortunes of some of these stocks turn around when the fog lifts and investors begin seeing them in a more balanced light. He cites Fannie Mae and Freddie Mac as two out-of-favor stocks that he believes will turn around once the firestorm over alleged improprieties at those firms blows over. Once they start shedding their negative images, investors will once again recognize that both have enjoyed earnings growth rates in the 15% range for several decades, and are selling at price-earnings multiples well below the market average.

Meir Statman

Glenn Klimek Professor of Finance

Santa Clara University

Advice: Advisor, heal thyself

Investors predict what the market will do by looking over their shoulders, says Statman, a leading academic in the field of behavioral finance. "Investors usually form expectations about the future from the recent past," he says. "They become more optimistic after the market has gone up, and more pessimistic after it has gone down."

Surveys support that observation. A Gallup poll taken in January 2004 indicated that investors expected to earn a 10% return in the coming year-about double what they expected to earn in the dark days of the fall of 2002. Even when investors acknowledge that the market is overvalued, he says, they often continue to invest because they think stocks can go even higher. "People are attracted to lottery tickets because they give them a chance to become very, very rich," he says. "Too many investors view stocks as their lottery ticket."

Status-seeking behavior exacerbates overoptimism. "Everyone wants to be richer than their brother-in-law or their neighbors," he says. "Advisors need to get the point across that even though a client may not be the richest person on the block, they're doing pretty well compared to the vast majority of people."

On the other hand, expectations for future returns fall sharply in down markets. A paper Statman co-authored recently notes that the mean stock market return investors anticipated for the 12 months following September 2001 was 6.3%, less than half of the mean 15.2% expected return in a survey conducted in February 2000, just before the market crash.

Yet turnarounds are possible when positive developments shine light on dark investor moods. Statman says that reports of improving earnings and signs of an economic recovery-particularly after a long period of concern over the possibility of a double-dip recession-provide at least a partial explanation of why investors felt emboldened enough to return to the stock market last year.

Scandals in the mutual fund industry and the corporate world did little to dampen investor enthusiasm and will probably have minimal long-term impact on the market, he says. "People are not naïve. They expect at least some corruption among executives. And many are not purists themselves. About half of those responding to one survey indicated they would act on an insider tip if they got one." Most people, he adds, do not see a relationship between greed in the mutual fund industry or the corporate world and their own investments.

As the bull market continues, Statman urges financial advisors to "adjust the aspirations of clients who look to the recent past to formulate an investment strategy. Financial advisors need to dampen down investor enthusiasm and expectations in a bull market, recommend appropriate diversification strategies, and remind people that no one can predict when the market will go down."

But first, they may need to curb their own enthusiasm. "Some advisors study the market so much that they see patterns that simply don't exist. They try to sound like gurus, and are overconfident in their ability to beat the market. Those individuals need to heal themselves before they can heal their clients."

Russell Fuller

Founder, RJF Asset Management

Advice: Exploit irrational behavior

When Russ Fuller began his investment career in the early 1970s as a sell-side analyst, he "couldn't understand why stock prices moved up and down." Returning to graduate school, becoming a professor, and combining his academic career with professional money management in the 1970s and 1980s brought him no closer to an answer.

The picture became somewhat clearer in 1990, when he decided to study behavioral finance during a sabbatical. He has since left the academic world behind, but continues to manage money based on what he learned about the topic 14 years ago.

Today, Fuller co-manages two mutual funds that base their investment strategies on behavioral finance theories. One, the J.P. Morgan Fleming Undiscovered Managers Growth Fund, relies on investors' tendency toward "anchoring" to find companies that have the potential for earnings surprises. "Psychologists have documented that when people make quantitative estimates, their estimates are heavily influenced by previous values of the item," he says. "That explains why a car salesman will start with a high figure and work his way down." Similarly, he says, earnings forecasts are a powerful anchor and analysts are very reluctant to revise them radically. The trick is finding companies that will deliver earnings surprises most people are not expecting.

Analysts also tend to be overconfident in their predictions, another bias that gives investors the opportunity to find companies that exceed market expectations. Fuller finds most earnings surprise stories in small and mid-sized companies in the technology sector, which comprises nearly half of fund assets, and consumer products and services, which account for nearly one-third of the portfolio.

In value and contrarian investing, the goal is to exploit investor overreaction to past negative information. "People evaluate the probability of an uncertain future event by the degree to which it is similar to a recently observed event," he says. "There are many cases where analysts stereotype beaten-down companies as permanent losers. But not all of them are." To find stocks for the J.P. Morgan Fleming Undiscovered Managers Behavioral Value Fund, Fuller looks for positive signs that others may be missing, such as insider buying among small-cap value companies. He usually finds them in sectors such as consumer products and services, technology, financial services and health care. Together, these sectors account for more than 80% of the fund portfolio.