Evaluating a stock’s “character” is risky business

Benj Gallander and Ben Stadelmann
Friday, March 10, 2006

In his best-selling book The Tipping Point, author Malcolm Gladwell examines the social dynamics of how fads, fashions and ideas reach a critical mass and explode into mainstream acceptance. Mr. Gladwell’s examples run the gamut, from the phenomenal success of children’s television shows Sesame Street and Blue’s Clues to the sudden drop in crime in New York in the early 1990s.

As for the business world, there are fascinating stories about ingenious marketing campaigns that were wildly successful and illustrate the book’s subtitle, “How Little Things Can Make a Big Difference.”

Mr. Gladwell has nothing to say overtly about the stock market, but his work would appear to fit snugly into the field of study known as behavioural finance. This branch of economics is diametrically opposed to the classical efficient-market theory, and emphasizes the psychological and social aspects of buying and selling decisions and risk assessment.

Ironically, behavioural finance itself seems to be slowly edging toward a tipping point. Though most economists still believe the market to be essentially rational, episodes like the dot-com frenzy have undermined that view. It is noteworthy that in 2002 the Nobel Prize in economics was awarded to Daniel Kahneman for “having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty.”

The most interesting section of Mr. Gladwell’s book regards his “Third Rule: The Power of Context.” He argues that how people behave in specific conditions does not necessarily have much to do with their character, knowledge or experience — though these things will predispose them to conduct themselves in a certain way. Instead, actions depend on details of the immediate environment and situation they find themselves in.

That concept may seem counterintuitive, or flat-out unbelievable. Most people would like to think that people of integrity don’t cheat on their taxes, beat their spouses, or give insider stock tips to in-laws. However upstanding citizens do sometimes commit those transgressions. When word of their breach is known, the reaction is often, “I can’t believe so-and-so would be capable of such a thing.”

Mr. Gladwell ascribes this error of imagining that character is something unified and all-encompassing to what psychologists call fundamental attribution error. According to this theory, people have a tendency to assume what a person does is based more on what “kind” of person he or she is, rather than due to specific social and environmental factors.

So if a car suddenly cuts us off on the freeway, we might shake a fist and scream, “You friggin’ idiot, you must have got your licence out of cereal box!” Perhaps he really is an awful driver. But he might have had a momentary lapse of concentration caused by a whining child in the backseat, nervousness about an important presentation, or any of a myriad of other possibilities that have nothing to do with his ability to drive.

Even experienced investors are frequently tripped by this type of thinking. On Report on Business Television the other day, a seasoned commentator explained that he would never buy a company that had had a major accounting problem in his lifetime.

Could a decades-old scandal really mean the company is eternally corrupt and untrustworthy? Maybe, but it would be far more likely that the trouble has been rectified, and if anything, the corporation is probably going to be very sensitive to proper accounting practices in the future.

The notion that certain companies are “bad” and should be forever avoided, while others are “great” and can be held in perpetuity, makes no more sense than believing that a juvenile delinquent will never amount to anything, or that paragons of virtue can do no wrong.

Investing has little to do with the stark black and white of Hollywood movies, where heroes and villains behave in perfectly predictable ways. Instead it requires attention to detail, sorting through the many layers of grey, to find that stock which is at the tipping point of success.