As an Investor, Martha Stewart Fell Victim to a Common Weakness

With her wealth, status and access to hot IPOs of the late 1990s, style diva Martha Stewart was no average investor.

But a professor of behavioral finance contends in a recent study that Stewart succumbed to an investing weakness that is far from extraordinary: a reluctance to sell either winning or losing stocks.

Meir Statman, professor at Santa Clara University in Santa Clara, Calif., reviewed brokerage account records entered as evidence in court as well as testimony in the trial.

Stewart, who founded Martha Stewart Living (MSO) and worked as a stockbroker early in her career, was sentenced to five months in prison Friday, having been convicted March 5 of lying to the government about her well-timed sale of about 4,000 shares of ImClone Systems(IMCL) in December 2001.

Here's a look at the stock trading the study analyzed.

On Dec. 20, 2001, her personal account at Merrill Lynch (MER) consisted of 25 stocks valued at $2,385,289. Of the 25 stocks, 22 had unrealized losses, including Amazon (AMZN), Apple (AAPL), Nokia (NOK), DoubleClick (DCLK), Lucent Technologies (LU) and Kmart Holdings (KMRT). For tax reasons, she sold these by year's end for a combined loss of $704,525.

In an email to a friend on Dec. 22, she wrote: "Just took lots of huge losses to offset some gains, made my stomach turn."

Stewart, according to Statman, was exhibiting that common investor weakness or "cognitive bias" known as framing, "where investors open mental accounts when they buy stocks and close them only when they sell the stocks.

"Investors do not have to acknowledge paper losses, because open accounts keep alive the hope that stock prices would rise and losses would turn into gains," Statman writes. "But hope dies when losses are realized. Realization of losses brings the pain of regret investors feel when they find, too late, that they would have had happier outcomes if only they avoided the losing stocks."