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.