Money Matters - Simplified

Why Chimpanzees Invest Better Than You


If you've ever seen the howling mob of chaos that regularly erupts on the floor of the New York Stock Exchange, you can probably understand the tendency to compare investors to a gaggle of apes. But a recent Duke University study has proved that investors and their primate pals a few rungs down the evolutionary ladder may not be quite as similar as you'd think.


If anything, the apes might be smarter.

Bonzo, meet Buffett
The Duke researchers tested chimpanzees and bonobos, the primates most like humans, with an experiment involving bowls of peanuts (eh, not bad), cucumbers (ugh), or bananas (jackpot!).

The researchers would show the apes two bowls, then offer them only one. When the apes knew they had a great chance of getting a banana, they were a lot more likely to take the gamble and pick a bowl. But when one of the bowls was covered, leaving its contents a mystery, the apes were far less likely to pick that bowl, unless the other bowl contained cucumbers (blech!) or nothing at all. As the researchers noted, "When [the apes] aren't certain of the odds or don't have confidence in their judgments, they're more likely to play it safe, rather than take a risk."

In the stock market, we highly evolved humans face similar choices. We can pursue investments that will provide us with modest but steady returns (the peanuts), or riskier stocks that could either pay off hugely (the banana!) or blow up in our faces (the cucumber).

Like the apes, we often make sensible choices -- as long as we have enough information on which to base our decisions. But when we don't understand the odds, we can wind up making terrible investments.

Many investors cling to bonds, thinking they're safer than stocks. That's true, but bonds' safety comes with a price. Most investors with decades to go until retirement should keep the bulk of their long-term money in stocks instead, since stocks have tended to outperform bonds over the long haul:

Holding Period

Stocks Beat Bonds This Amount of the Time

One year 59.4%
Five years 71.0%
10 years 81.2%
20 years 94.9%
30 years 100.0%

Source: Stocks for the Long Run, Jeremy Siegel. Data from 1871 to 2008.

Fixed-income investments may be more stable, but they're not nearly as effective in building the nest egg you'll need to avoid a gruesome retirement. Failing to understand that can leave your golden years a mess.

Keep the odds on your side
If you want to play it safer without sandbagging your returns, there are lots of ways to keep the odds in your favor. Just like our primate friends will favor a bowl of adequately tasty peanuts over a bowl they suspect may contain cucumbers, risk-averse investors can stick to stocks of defensive companies that generally fare better in a tough economy.

In 2008, while the S&P 500 fell 37% and consumers cut back on discretionary purchases such as cars and expensive pants, shares of Ford (NYSE: F) and Joe's Jeans (Nasdaq:JOEZ) plunged 66% and 71%, respectively. But no matter what the economy does, people will still keep buying medications, shampoo, electricity, cigarettes, and inexpensive treats. Thus, shares of MedcoHealth Solutions (NYSE: MHS) fell only 17%, while McDonald'sactually rose 8%. These are defensive companies.

Of course, those investing for the very long term needn't worry too much about cyclical companies -- Ford has been turning itself around, and many consumers can only postpone new car purchases so much. Joe's Jeans nearly quadrupled in 2009, and its sales have been growing, though that owes partly to some big discounts. Understanding the power of defensive companies can give your portfolio more stability.

Seek margins of safety
Those clever apes do take a chance on a bowl of bananas when they feel that the odds are in their favor. We can do the same by seeking a margin of safety in our investments.

Many investors are bullish on Netflix (Nasdaq: NFLX), lauding the strong growth of its streaming video service, which carries a higher profit margin than its DVD-mailing operations. But the stock is already trading more than six times higher than it was two years ago, and its recent P/E ratio of 73 is more than twice its five-year average. Some investors now question whether it will face bandwidth problems -- recent data suggests that Netflix streaming represents 20% of all downstream Internet traffic in the U.S. during peak evening hours -- or will have to spend too much to secure content.

All of that makes Netflix more risky than companies with strong growth rates, modest P/E ratios, and solid returns on equity (ROE). Here are just a few a simple screen turned up:

Company

3-Year Avg. Revenue Growth

ROE

P/E

Cirrus Logic (Nasdaq: CRUS) 21% 34% 14
China Fire and Security (Nasdaq: CFSG) 27% 18% 10
Tata Motors (NYSE: TTM) 49% 36% 18

Data: Capital IQ, a division of Standard and Poor's; Motley Fool CAPS.

Cirrus Logic has been profiting from the brisk sales of iPads for which it makes audio chips. It's also developing smart-grid energy products to serve a high-margin industry. Meanwhile, as China grows and builds, its demand for safety technology will also expand. China Fire and Security not only offers a compelling valuation, but access to the huge and still-developing Chinese market, as well. Finally, India-based Tata Motors also offers international exposure and plenty of promise, manufacturing both high-end (Jaguar, Land Rover) and low-end (Nano) vehicles, along with many of India's trucks and buses.

Don't get outsmarted by a bonobo. Make sure you know as much about the odds as possible before you invest. Take on risk only when you know enough about your chances to expect a good result. When you don't, play it safe with your investments -- a modest return is still better than a painful loss.

Unless, of course, you really like cucumbers.

© 2010 UCLICK L.L.C.