12 Russ Wermers, “Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transaction Costs, and Expenses,” Journal of Finance 55 (August 2000): 1655-1703.
13 Yahoo provides the risk classifications (above average, average, and below average) based on the standard deviation of portfolio performance. I quantified the three levels, allocating a value of 1 for funds with below-average risk, 2 for average-risk funds, and 3 for above-average-risk funds, in order to attain an average risk level for each turnover range. The numbers are on an asset-weighted basis.
11. All I Really Need to Know I Learned at a Tupperware Party
1 Robert B. Cialdini, “The Science of Persuasion,” Scientific American (February 2001): 76-81.
2 Robert B. Cialdini, Influence: The Psychology of Persuasion (New York: William Morrow, 1993), 18.
3 See chapter 11.
4 For an interesting account of Asch’s experiment, see Duncan J. Watts, Six Degrees: The Science of a Connected Age (New York: W. W. Norton & Company, 2003), 207-10.
5 Cialdini, Influence, 208-15. Also see Rod Dickinson, “The Milgram Reenactment,” http://www.milgramreenactment.org/pages/section.xml?location=51.
6 Lisa W. Foderaro, “If June Cleaver Joined ‘Sex and the City’: Tupperware Parties for the Cosmo Set,” The New York Times, February 1, 2003.
7 Cialdini, Influence, 37.
12. All Systems Go
1 Antonio R. Damasio, Descartes’ Error: Emotion, Reason, and the Human Brain (New York: Avon Books, 1994), xi-xii.
2 Thomas A. Stewart, “How to Think With Your Gut,” Business 2.0, November 2002.
3 Antonio R. Damasio, The Feeling of What Happens: Body and Emotion in the Making of Consciousness (New York: Harcourt Brace & Company, 1999), 301-3. Antoine Bechara, Hanna Damasio, Daniel Tranel, and Antonio R. Damasio, “Deciding Advantageously Before Knowing the Advantageous Strategy,” Science 275 (February 28, 1997): 1293-95.
4 Daniel Kahneman, “Maps of Bounded Rationality: A Perspective on Intuitive Judgment and Choice,” Nobel Prize Lecture, December 8, 2002, http://www.nobel.se/economics/laureates/2002/kahnemann-lecture.pdf.
5 Paul Slovic, Melissa Finucane, Ellen Peters, and Donald G. MacGregor, “The Affect Heuristic,” in Heuristics and Biases: The Psychology of Intuitive Judgment , ed. Thomas Gilovich, Dale Griffin, and Daniel Kahneman (Cambridge: Cambridge University Press, 2002), 397-420.
6 Slovic, Finucane, Peters, and MacGregor, “The Affect Heuristic.”
7 Donald G. MacGregor, “Imagery and Financial Judgment,” The Journal of Psychology and Financial Markets 3, no. 1 (2002): 15-22.
13. Guppy Love
1 More accurately, the choice depends on how much the males diverged in coloration. When the difference was small, the females chose the less orange of the two. But if the male colors were sufficiently different, the females disregarded the cues from the others and went with the brighter hue. See Lee Alan Dugatkin and Jean-Guy J. Godin, “How Females Choose Their Mates,” Scientific American, April 1998, 56-61.
2 Lee Alan Dugatkin, The Imitation Factor (New York: Free Press, 2000).
3 See Carl Anderson and John J. Bartholdi III, “Centralized Versus Decentralized Control in Manufacturing: Lessons from Social Insects,” in Complexity and Complex Systems in Industry, ed. Ian P. McCarthy and Thierry Rakotobe-Joel (Warwick: University of Warwick, 2000), 92-105; http://www2.isye.gatechedu/˜carl/papers/cc.pdf.
4 For a discussion about the limits of arbitrage, see Andrei Shleifer, Inefficient Markets: An Introduction to Behavioral Finance (Oxford: Oxford University Press, 2000).
5 Investors should also note that feedback operates at different levels. There can be feedback at the product level, the company level, and the market level. Sometimes these layers of feedback are correlated; at other times they’re not.
6 Sushil Bikhchandani and Sunil Sharma, “Herd Behavior in Financial Markets,” IMF Staff Paper 47, no. 3 (2001), http://www.imf.org/External/Pubs/FT/staffp/2001/01/pdf/bikhchan.pdf.
7 Sushil Bikhchandani, David Hirshleifer, and Ivo Welch, “Informational Cascades and Rational Herding: An Annotated Bibliography,” Working Paper: UCLA/Anderson and Michigan/GSB (June 1996).
8 Duncan J. Watts, “A Simple Model of Global Cascades on Random Networks,” Proceedings of the National Academy of Sciences 99, no. 9 (April 30, 2002): 5766-71.
9 Anderson and Bartholdi, “Centralized Versus Decentralized Control.”
10 Charles MacKay, Extraordinary Popular Delusions and the Madness of Crowds (1841; New York: Three Rivers Press, 1995).
11 Russ Wermers, “Mutual Fund Herding and the Impact on Stock Prices,” Journal of Finance 54, no. 2 (April 1999): 581-622.
12 Ivo Welch, “Herding Among Security Analysts,” Journal of Financial Economics 58, no. 3 (December 2000): 369-96.
13 Victor M. Eguiluz and Martin G. Zimmerman, “Transmission of Information and Herd Behavior: An Application to Financial Markets,” Physical Review Letters 85, no. 26 (December 25, 2000): 5659-62.
14 J. Bradford DeLong, Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann, “Positive Feedback Investment Strategies and Destabilizing Rational Speculation,” Journal of Finance 45, no. 2 (June 1990): 379-95.
14. Beware of Behavioral Finance
1 Most experts agree that the starting point for the field came in 1985 with a landmark paper: Werner DeBondt and Richard Thaler, “Does the Stock Market Overreact?” Journal of Finance 40 (1985): 793-805.
2 See Alfred Rappaport and Michael J. Mauboussin, “Pitfalls to Avoid,” at www.expectationsinvesting.com/pdf/pitfalls.pdf.
3 Hersh Shefrin, Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing (Boston: Harvard Business School Press, 2000), 5.
4 Vernon L. Smith, “An Experimental Study of Competitive Market Behavior,” Journal of Political Economy 70, no. 3 (June 1962): 111-37.
5 Andrei Shleifer, Inefficient Markets: An Introduction to Behavioral Finance (Oxford: Oxford University Press, 2000), 3. A few pages later, Shleifer is bolder: “It is this argument that the Kahneman and Tversky theories dispose of entirely” (12).
6 Sherry Sontag and Christopher Drew, Blind Man’s Bluff: The Untold Story of American Submarine Espionage (New York: Perseus Books, 1998), 58-59.
7 Jack L. Treynor, “Market Efficiency and the Bean Jar Experiment,” Financial Analysts Journal (May-June 1987), 50-53.
8 This is not true for corporate executives. Individual decision-making errors can have a significant negative effect on shareholder value. One good example is the winner’s curse, where a company that wins an auction for an asset (winner) tends to overpay for the asset (curse).
9 See chapter 11.
15. Raising Keynes
1 W. Brian Arthur, “Inductive Reasoning and Bounded Rationality: The El Farol Problem,” paper given at the American Economic Association Annual Meetings, 1994, published in American Economic Review (Papers and Proceedings) 84 (1994): 406-11, http://www.santafe.edu/arthur/Papers/El_Farol.html.
2 For a good discussion of expectation formation, see Karl-Erik Wärneryd, Stock-Market Psychology (Cheltenham, UK: Edward Elgar, 2001), 73-95.
3 See Bob Davis and Susan Warren, “How Fears of Impending War Already Take Economic Toll,” The Wall Street Journal, January 29, 2003.
4 John Maynard Keynes, The General Theory of Employment (New York: Harcourt, Brace and Company, 1936), 162.
5 Ibid., 159.
6 John C. Bogle, “The Mutual Fund Industry in 2003: Back to the Future,” remarks before the Harvard Club of Boston, January 14, 2003, http://www.vanguard.com/bogle_site/sp20030114.html.
7 This section relies heavily on Arthur, “Inductive Reasoning.”
8 Corinne Coen and Rick Riolo, “El Farol Revisited: How People in Large Groups Learn to Coordinate Through Complementary Scripts,” Organizational Learning and Knowledge Management conference proceedings, 4th International Conference, June 2001.
9 Max Bazerman,
Judgment in Managerial Decision Making, 4th ed. (New York: Wiley, 1998), 36-39.
10 Hersh Shefrin, Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing (Boston: Harvard Business School Press, 2000), 199.
16. Right from the Gut
1 Thomas A. Stewart, “How to Think with Your Gut,” Business 2.0, November 1, 2002, http://money.cnn.com/magazines/business2/business2_archive/2002/11/01/331634/index.htm.
2 Ibid.
3 Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk (New York: John Wiley & Sons, 1996), 99-100.
4 Raanan Lipshitz, Gary Klein, Judith Orasanu, and Eduardo Salas, “Taking Stock of Naturalistic Decision Making,” Working Paper, July 15, 2000, http://organizations.haifa.ac.il/html/html_eng/raanan%20-%20taking.doc.
5 Robert A. Olsen, “Professional Investors as Naturalistic Decision Makers: Evidence and Market Implications,” The Journal of Psychology and Financial Markets 3, no. 3 (2002): 161-67.
6 Ibid., 162-63.
7 Michael T. Kaufman, Soros: The Life and Times of a Messianic Billionaire (New York: Knopf, 2002), 141.
8 Gary Klein, Sources of Power: How People Make Decisions (Cambridge, Mass.: MIT Press, 1998), 161-66.
9 Stewart, “How to Think with Your Gut.”
10 For more on the unconscious, see Frank Tallis, Hidden Minds: A History of the Unconscious (New York: Arcade Publishing, 2002), 95-109.
17. Weighted Watcher
1 http://www.brainyquote.com/quotes/authors/a/antoine_lavoisier.html.
2 http://www.phrases.org.uk/meanings/375700.html.
3 http://www.usdoj.gov/atr/cases/exhibits/20.pdf.
4 Dale Griffin and Amos Tversky, “The Weighing of Evidence and the Determinants of Confidence,” in Heuristics and Biases: The Psychology of Intuitive Judgment , ed. Thomas Gilovich, Dale Griffin, and Daniel Kahneman (Cambridge: Cambridge University Press, 2002), 230-49.
5 Richard H. Thaler, The Winner’s Curse: Paradoxes and Anomalies of Economic Life (Princeton, N.J.: Princeton University Press, 1994).
6 The 2003 sale of the Sears credit card portfolio is a vivid illustration of this point. Some investors were short the stock, believing the disposition price for the business would be below management guidance, and many potential buyers for the asset confirmed this view. But the buyer ended up paying more than what the average bidder thought the business was worth.
7 One example is of a former CSFB analyst, who in 2000 spent two days as a temporary employee, filling orders for an Amazon.com distribution center. Some generous math suggests he filled no more than $15,000 worth of orders in a quarter when the company generated $1 billion in sales. Yet the experience generated a research report and plenty of press.
8 Tarun Chordia, Richard Roll, and Avanidhar Subrahmanyam, “Evidence on the Speed of Convergence to Market Efficiency,” Working Paper, April 29, 2002. Also Eugene F. Fama, Lawrence Fisher, Michael C. Jensen, and Richard Roll, “The Adjustment of Stock Prices to New Information,” International Economic Review 10, no. 1 (February 1969); 1-21.
9 Stefano DellaVigna and Joshua Pollet, “Attention, Demographics, and the Stock Market,” Working Paper, November 23, 2003, http://fisher.osu.edu/fin/dice/seminars/pollet.pdf.
10 See chapter 1.
11 http://www2.cio.com/techpoll/index.cfm.
12 Amos Tversky and Daniel Kahneman, “Extensional Versus Intuitive Reasoning: The Conjunction Fallacy in Probability Judgment,” in Heuristics and Biases: The Psychology of Intuitive Judgment, ed. Thomas Gilovich, Dale Griffin, and Daniel Kahneman (Cambridge: Cambridge University Press, 2002), 19-48.
13 Sanford J. Grossman and Joseph E. Stiglitz, “On the Impossibility of Informationally Efficient Markets,” American Economic Review 70 (1980): 393-408.
18. The Wright Stuff
1 Evolutionary economists Richard Nelson and Sidney Winters echo the same theme. They write, “Innovation in the economic system—and indeed the creation of any sort of novelty in art, science, or practical life—consists to a substantial extent of a recombination of conceptual and physical materials that were previously in existence. The vast momentum in scientific, technological, and economic progress in the modern world derives largely from the fact that each new achievement is not merely the answer to a particular problem, but also a new item in the vast storehouse of components that are available for use, in ‘new combinations, ’ in the solution of other problems in the future.” Richard R. Nelson and Sidney G. Winter, An Evolutionary Theory of Economic Change (Cambridge, Mass.: Harvard University Press/Belknap Press, 1982), 130.
2 Based on Romer’s comments at a roundtable discussion held June 17, 1998, Pebble Beach, Calif., reproduced as Donald Lessand, moderator, “The Soft Revolution: Achieving Growth By Managing Intangibles,” The Journal of Applied Corporate Finance 11, no. 2 (Summer 1998): 8-27.
3 Quoted in Stephen R. Waite, Quantum Investing (New York: Texere, 2002), 1-3.
4 The evolution of technique in sports shows the power of nonrival goods. Examples include the crawl swim stroke (which only became widespread within the past 200 years), overhand free-throw shots in basketball, and the Fosbury flop for high jumpers.
5 “Moore’s law is the empirical observation that at our rate of technological development, the complexity of an integrated circuit, with respect to minimum component cost will double in about 24 months” (http://en.wikipedia.org/wiki/Moore’s_Law).
6 Juan Enriquez, As the Future Catches You (New York: Crown Business, 2000), 62-65.
7 See http://nickciske.com/tools/binary.php.
19. Pruned for Performance
1 Steven Pinker, The Language Instinct: How the Mind Creates Language (New York: HarperCollins, 1994), 150-51.
2 Alison Gopnik, Andrew Meltzoff, and Patricia Kuhl, The Scientist in the Crib: What Early Learning Tells Us About the Mind (New York: First Perennial, 2001), 186-87.
3 Joseph LeDoux, Synaptic Self: How Our Brains Become Who We Are (New York: Viking, 2002), 79-81.
4 Robert Aunger, The Electric Meme: A New Theory of How We Think (New York: Free Press, 2002), 185.
5 Barbara Clancy and Barbara Finlay, “Neural Correlates of Early Language Learning,” in Language Development: The Essential Readings, ed. Michael Tomasello and Elizabeth Bates (Oxford: Blackwell, 2001); an earlier version of the chapter is available from http://crl.ucsd.edu/courses/commdis/pdf/neuralcorrelateschapter-nofigures.pdf.
6 Michael J. Mauboussin and Alexander Schay, “Fill and Kill: Succeeding with Survivors Is Nothing New,” Credit Suisse First Boston Equity Research, April 5, 2001.
7 See http://www.webmergers.com.
8 David M. Raup, Extinction: Bad Genes or Bad Luck? (New York: W. W. Norton, 1991), 32-33.
9 William D. Bygrave, Julian E. Lange, J. R. Roedel, and Gary Wu, “Capital Market Excesses and Competitive Strength: The Case of the Hard Drive Industry, 1984-2000,” Journal of Applied Corporate Finance 13, no. 3 (Fall 2000), 8-19.
20. Staying Ahead of the Curve
1 In fact, one of the new leader’s first actions is often to kill all of the cubs in the pride. This allows the new leader to sire new cubs that carry his genes.
2 See Richard Foster and Sarah Kaplan, Creative Destruction: Why Companies That Are Built to Last Underperform the Market—and How to Successfully Transform Them (New York: Doubleday, 2001), 47.
3 Alfred Rappaport and Michael J. Mauboussin, Expectations Investing: Reading Stock Prices for Better Returns (Boston: Harvard Business School Press, 2001).
4 See Foster and Kaplan, Creative Destruction; Everett Rodgers, The Diffusion of Innovation (New York: Free Press, 1995); and Geoffrey A. Moore, Paul Johnson, and Tom Kippola, The Gorilla Game: Picking Winners in High Technology (New York: HarperBusiness, 1999).
5 Michael J. Mauboussin and Alexander Schay, “Innovation and Markets: How Innovation Affects the Investing Process,” Credit Suisse First Boston Equity Research, December 12, 2000.
6 Gregory Zuckerman, “Stars of the ’90s Ar
en’t Likely to Lead the Next Rally,” Wall Street Journal, December 17, 2001.
7 John Y. Campbell, Martin Lettau, Burton G. Malkiel, and Yexiao Xu, “Have Individual Stocks Become More Volatile?” Journal of Finance 54 (February 2001): 1-43.
8 Corporate Strategy Board, “Stall Points: Barriers to Growth for the Large Corporate Enterprise,” Corporate Strategy Board (March 1998).
9 Alfred Rappaport and Michael J. Mauboussin, “Exploiting Expectations,” Fortune, January 21, 2002, 113-15.
21. Is There a Fly in Your Portfolio?
1 For readers with too much time on their hands, see: http://www.ceolas.org/fly/intro.html.
2 Charles H. Fine, Clockspeed: Winning Industry Control in the Age of Temporary Advantage (Reading, Mass.: Perseus Books, 1998).
3 Glenn Rifkin, “GM’s Internet Overhaul,” Technology Review (October 2002): 62-67.
4 Eugene F. Fama and Kenneth R. French, “Disappearing Dividends: Changing Firm Characteristics Or Lower Propensity To Pay?” CRSP Working Paper 509, June 2000; see http://papers.ssrn.com/sol3/papers.cfm?abstract_id=203092.
5 Robert R. Wiggins and Timothy W. Ruefli, “Sustained Competitive Advantage: Temporal Dynamics and the Incidence and Persistence of Superior Economic Performance,” Organizational Science 13, no. 1 (January-February 2002): 82-105.
6 Robert R. Wiggins and Timothy W. Ruefli, “Hypercompetitive Performance: Are The Best of Times Getting Shorter?” paper presented at the Academy of Management Annual Meeting 2001, Business Policy and Strategy (BPS) Division, March 31, 2001.
7 While I believe this hypothesis is likely true, I’m less convinced that the data support it. The main reason is that the later years of the study included historically high levels of write-offs and restructuring charges that likely distorted the accounting data.
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