“When a Stock Goes Down, It’s Good News”
When I went to Best Buy (BBY) on Black Friday, I was hoping to buy a Sharp 50-inch LED 4K Ultra HD TV for $179.99—a TV that normally would have cost $599.99.
That’s a 70% discount from the regular price! Unfortunately, it was sold out.
Everyone likes a bargain – and a bargain stock.
But not always.
If a stock dropped 70% for a temporary reason, would you call it a bargain? Many investors would rush to sell, putting more downward pressure on the price. For value investors, however, such an event is Black Friday! They call their broker and order as much as they can buy the bargain stock at that 70% discount. In Warren Buffett’s words: when a stock goes down, it’s good news.
There are multiple psychological factors for this paradox, and today, I will explore how some psychological biases affect value investors, who tend to move away from rationality in such extreme circumstances.
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Consider a simple thought experiment in two parts. You’re playing the role of a hard-core value investor, by which I mean you have a clear-cut idea of the intrinsic value of a stock, and are confident that at some point (whether in a day or a decade), the stock price will get close to its intrinsic value.
Here’s the first case. Imagine you have invested in Apple (AAPL), which is trading at 174 today. You firmly believe that the stock is worth 250 a share with a reasonable margin of safety. But tomorrow, at noon, news comes out that a few iPhone X batteries have exploded—and Apple stock falls 50%.
Would you panic? Would you sell your shares in the fear that AAPL would tank further? Or would you buy more?
In the second case, shift the thought experiment by imagining that you did not own any shares of Apple when it went into free fall.
Even a well-trained value investor will approach these two thought experiments differently. The propensity to make a misjudgment in the first case would be typically much higher than the second case. Three psychological fallacies explain this difference.
First is the fallacy of social proof, which is an evolutionary trait of following the crowd. It requires a disciplined approach to think against the crowd. If you owned Apple stock when it plunged, you would need guts, not only to resist selling it, but also to buy more. When you lose big with the crowd, it requires a strong will to go against the crowd. You share the same sentiments as those who have lost with you, and you tend to take opinions from them.
However, if you did not own AAPL stock, you had only one decision to make—either to buy or not—making the judgment much simpler.
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The Bargain Stock Bias
The second is the fallacy of sunk cost, where an investor assumes the fallacy of recovering the unrecoverable cost. For example, when I failed to find the 50-inch Sharp TV I was looking for at my local Best Buy, I spent a lot of time checking other Best Buy stores in Connecticut—and when I finally found one I drove a long way to buy it. It wasn’t that I truly needed the TV. I just didn’t want to feel like I had wasted my time and money. That time—and the gas I had used looking—were sunk costs, not recoverable.
So going back to the Apple example, if you had owned Apple stock when it fell 50%, you might brood over your sunk cost and decline to buy any more. However, if you didn’t own the stock, you might tend to act more rationally and buy the bargain stock.
Third is the endowment effect—you love things that you own. In the first thought experiment, you owned Apple stock, and thus you tended to have an emotional connection to it. When it fell, you were disappointed and developed a dislike for it. This emotion makes it even harder to buy more.
When you are not emotionally connected to the stock, it is easier to take a more rational approach.
Having said that, you need more than simple rationality to invest in stocks that have fallen. You also need to intellectually re-examine your estimate of fair value. In the case of Apple, the big questions revolve around how consumers react to the iPhone X battery problem, how quickly the company fixes the problem, and how the brand’s reputation evolves in the long run.
If the correction signals the start of a long downgrading of Apple’s brand in the hearts of consumers, the value investor’s calculations need to be revised. But if the battery problem is just a blip, and the brand remains highly esteemed, then the long-term value case remains intact and the selloff is just another opportunity for the disciplined long-term investor to get a good stock at a bargain.
Timothy Lutts heads one of America’s most respected independent investment advisory services. Each week, Tim personally picks the single best stock in his exclusive Cabot Stock of the Week advisory. Build your wealth and reduce your risk with the top stock each week for current market conditionsLearn More