Temple University mathematics professor John Allen Paulos, author of Innumeracy (Hill 2001) and the more recent A Mathematician Plays the Stock Market (Basic 2003), wrote this insightful Wall Street Journal ($) op-ed yesterday in which he describes how even a bright mathematics professor who knows better can get caught up in the irrational exuberance of a stock bubble:

Bernie Ebbers’s testimony yesterday that he emphatically was not aware that his accountants were cooking WorldCom’s books while he was CEO brought back unpleasant memories of my disastrous “relationship” with the man. It began in 2000, when I received a small and totally unexpected sum of money. I considered it “mad money,” a term that, in retrospect, seems all too appropriate. Nothing distinguished the money from my other assets except this private designation, but being so classified made my modest windfall more vulnerable to whim. In this case it entrained a series of ill-fated, and much larger, investments in what WorldCom’s ads called “the pre-eminent global communications company for the digital generation.”

Professor Paulos goes on to explain how his limited research into WorldCom validated his interest in the stock, so he bought a few shares. And then:

After buying the initial shares, I found myself idly wondering, Why not buy more? I didn’t think of myself as a gambler, but I willed myself not to think, willed myself simply to act, willed myself to buy more shares of WCOM, shares that cost considerably more than the few I’d already bought. Usually a hard-headed fellow, I nevertheless succumbed to confirmation bias, looking disproportionately hard for what made my investment look good and essentially ignoring everything that made it look bad. This wasn’t difficult, given the stellar reports and strong buy recommendations that analysts kept bringing forth. In any case, I fell in love with the stock and saw every drop in its price as bringing about an even better buying opportunity. So-called averaging down (buying more shares when the price drops) is often indistinguishable from catching a falling knife, and in my case the result was thoroughly bloody hands.

Unfortunately, Professor Paulos found his initial bias toward the WorldCom stock hard to shake:

I’d grown tired of carrying on one-sided arguments with TV and online commentators as they delivered relentlessly bad news about WorldCom. So, in late fall 2001, some six months before its final swoon, I contacted a number of them and, having spent too much time in the immoderate atmosphere of WorldCom chatrooms, I chided them for their shortsightedness and exhorted them to look at the company differently.
Finally, out of frustration with the continued decline of WCOM stock, I even e-mailed Bernie Ebbers in early February 2002, suggesting that the company was not effectively stating its case and quixotically offering to help in any way that I could. WorldCom, I fatuously informed him, was well positioned, but dreadfully undervalued.
Even as I was writing them, I knew that sending these electronic epistles was absurd, but it gave me the temporary illusion of doing something about the free-falling stock. The realization that doing so had indeed been a no-brainer was glacially slow in arriving, and I didn’t dump it until April 2002, after it had lost almost all value. I gradually woke from this nightmarish infatuation with WorldCom to wonder how it had transformed me from a prudent investor in low-fee index funds into a monomaniacal speculator in a single dubious company.

Mr. Paulos concludes by answering his own question in the context of the ongoing sriminal trial of Mr. Ebbers:

Whatever the [Ebbers] trial’s outcome, however, I’ve long since come to a verdict on my behavior: guilty of stupidity in the first degree. No jail term, just a very substantial fine.

Yet, the ever-insightful Professor Ribstein notes in this post that attempting to deter this type of investor bravado through government regulation really just ensures that such irrational exuberance will eventually reappear:

A cause of the recent frauds is investors’ belief that they can outguess the market. Unfortunately, this erroneous belief is perpetuated and entrenched by court decisions and regulation that convey the impression that the markets are, again, safe for this foolish activity.

Quoting from a draft of his paper, Market v. Regulatory Responses to Corporate Fraud, 28 J. Corp. L. 1 (2002, Professor Ribstein observes:

Corporate frauds arguably were facilitated because there was too much investor confidence, as indicated by investors’ willingness to ignore what the market knew about questionable accounting and to not question firms’ extravagant claims about unproven business plans. Overselling regulation might perpetuate this misjudgment and mislead investors back into the same complacency that contributed to the recent frauds.