Let’s Make a Deal!
Common Psychological Pitfalls
Good Defense and Growth Stock
Over the holidays my family and I headed to see my out-laws in Michigan, and besides terrible company, watered-down whiskey and awful food, it was a decent time. Nah, I’m just teasing-the food wasn’t all that bad. (Thank you! I’ll be here all night! Try the veal it’s delicious!)
In all seriousness, it was fun and (mostly) relaxing, and I had some time to both get away from the market a bit (recharging the batteries is necessary in this business, I don’t care what anyone says) and also reflect as I usually do on some investing basics that, because of the stresses of day-to-day life in the market, I don’t have much time to address.
Both of these came to an intersection last week when, for no reason at all, I remembered an old math conundrum that I initially read in the book “The Curious Story of the Dog in the Nighttime” a few years ago. (Pretty good but unusual book, FYI.) So I Googled it and found that the paradox is better known as the Monty Hall problem, named after the host of the popular game show Let’s Make a Deal.
To quote Wikipedia ,the brain teaser goes like this: Suppose you’re on a game show, and you’re given the choice of three doors: Behind one door is a car; behind the others, goats. You pick a door, say No. 1, and the host, who knows what’s behind the doors, opens another door, say No. 3, which has a goat. He then says to you, “Do you want to pick door No. 2?” Is it to your advantage to switch your choice? (There are some specific rules here-the host must always reveal a goat, never open a door picked by the player and offer a chance to switch from the chosen door.)
Logically, the vast majority of people say that it doesn’t matter-there’s one car, and you know that door No. 3 has a goat. Thus, it’s a 50-50 shot that the car is behind either door No. 1 or door No. 2. So switching to door No. 2 doesn’t improve your odds.
But that’s incorrect! It turns out, through probability analysis, you actually have a 67% chance of picking the car if you switch to door No. 2. If you’re interested in why (and it’s a pretty neat read if you’re into this sort of thing), dive into the Wikipedia entry. But, even if you don’t, take my word that it’s been proven to be true.
What I want to focus on is the fact that, after this paradox was revealed many years ago, there was a mini-furor over the revealed result-the author (Marilyn vos Savant, who in the late 1980s had the highest IQ in the Guinness Book of World Records) got 10,000 letters from readers claiming she was wrong. And that included tons from PhDs!
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While I can’t speak to the PhDs, the psychology behind this fierce resistance is also seen often in the stock market. One reason is that people don’t like to switch; they overrate the winning probability of the door they’ve already chosen. We see that in the market all the time-having done the research and staked their pride to a stock via the purchase of a good-sized position, investors usually stick to their choice through thick and thin, no matter what the feedback (i.e., market prices).
Similar but slightly different is that, if people make an error, they feel better if it’s because of omission (lack of action), rather than because of taking an explicit action. In other words, if you don’t switch doors and lose, oh well … but if you switch doors and lose, people will say “oh I can’t believe you had the car in your hands but lost and overthought it!”
In the market, that often results in sticking with the herd mentality, even if you end up losing money. I actually heard this from a fellow at the pub the other day during the football games-he was talking about how he got hit with the recent oil stock meltdown. But his mentality was “Hey, what can you do? They’re good companies.” In other words, because nobody predicted oil and gas prices falling apart, it was acceptable to get caught and ride these stocks down.
Don’t get me wrong: I’m not saying he should hate himself or quit investing-none of that is productive, either-or that I never get stung with the occasional big loss. But when the unexpected happens, the smart investor works on finding out how he can avoid getting caught in the future.
Anyway, not only is the Monty Hall paradox a fun mind-bender during the holidays, it’s a great example of how common psychological pitfalls hurt the common investor.
On to the market, I’m relatively bullish. Not only did the market snap back powerfully from its early-December retreat, but we saw a couple of “blast-off” indications-rare signs of power that almost always portend solid market returns during the next three to nine months. (These involved volume and breadth “thrusts” over a few days that represent a sudden change of perception for the better.) Of course, there are never any guarantees in the market, but these signals tell me the odds favor the bull market continuing for at least the next few months.
On a stock-by-stock basis, though, things are still a bit tricky. Sure, some of that difficulty arises from typical end-of-year wiggles, as some funds lock in their year, other investors book losses and some institutions engage in window dressing. But I’m still seeing most of the action in either cyclical stocks (transports and airlines, for instance, which are also benefitting from plunging fuel prices) and “defensive growth” stocks that have a lot of surety in their business.
That doesn’t mean growth stocks are doing poorly, though-I’m seeing a bunch in tight, proper-looking launching pads, with a few nosing to new highs in recent days.
One stock, featured in Cabot Top Ten Trader, that mixes both defensive and growth characteristics is Avago Technologies (AVGO) a chipmaker that has historically done great business in smartphones, and that hit a homerun with its acquisition of LSI’s storage business earlier this year. The purchase diversified the business, gave it exposure to another huge and profitable growth area, and resulted in tons of synergies that are driving earnings through the roof. Indeed, analysts see the 2015 fiscal year (ending in October) bringing nearly $7.50 in earnings per share, and that’s likely conservative given that Avago has crushed estimates since the LSI deal was finalized.
The big catalyst, modest dividend (1.4% annual yield), reasonable valuation (14 times next year’s estimate) and history of top-notch execution are giving big investors reason to accumulate. AVGO isn’t in the first inning of its advance, but it’s set up a nice, tight sideways shelf following its huge earnings report in early December. I think you can nibble here or on dips, with a stop in the low 90s.
For more updates on Avago Technologies and to find out about additional momentum stocks featured in this week’s issue, consider taking a risk-free subscription to Cabot Top Ten Trader. This year, we grabbed many double and triple-digit winners, including 303% gains in VipShop Holdings, 126% gains in Canadian Solar, 133% gains in Netflix, and we see many more strong stocks that have the possibility to be next year’s winners.
Chief Analyst, Cabot Market Letter
And Cabot Top Ten Trader