Investor illogic: Why do we want to buy more AFTER the stock price rises?

SENSIBLE DOLLARS

By Allan Kunigis

Allan Kunigis is a Canadian-born freelance financial writer based in Shelburne, Vermont. He has written about personal finance for more than two decades. He is the author of A Kid’s Activity Book on Money and Finance: Teach Children About Saving, Borrowing, and Planning for the Future, published in September 2020.

Imagine people getting excited over the rising priceof milk, bread, or toilet paper, and, based on that price hike, these consumers clamour to buy more of that now pricier grocery item. Then, imagine the opposite: That jug of milk, loaf of bread, or package of bathroom tissue plummets in price, and people suddenly find the item much less attractive.

The central idea is not to pay more than the stock’s so-called “intrinsic value” -- a fundamental, objective measure of its value – no matter how attractive it appears or how dominant the company might be today.

That’s basically what happens with investmentswhen a herd mentality rules, as often happensduring a market bubble. Investors chase the latesthot thing – Bitcoin, shares of GameStop stock, or the latest shiny object being hyped. The demand for investments that have already skyrocketed makes no sense when compared with our approach to everyday grocery items.

LOGIC AND RIGOR AND FACTS – OH, MY!

Disciplined investors, like Warren Buffett or his hero/mentor, Benjamin Graham, the father of value investing, are famous for applying a logical, rigorous approach to investing. They use formulas, like the stock’s price-to-earnings ratio, its price-to-book ratio ,its debt-to-equity ratio, or its free cash flow.

Each of these metrics is distinct, but all have onething in common: paying for value. The central idea is not to pay more than the stock’s so-called“intrinsic value” -- a fundamental, objective measure of its value – no matter how attractive it appears or how dominant the company might be today. Consider Facebook, Amazon, Apple, Netflix, or Google (whose mother company is now known as Alphabet). These so-called FAANG stocks have crushed the competition in their respective markets, and their stock prices have soared. But at somepoint, they could be – or perhaps already are –overpriced.

Who knows what drastic changes might occur, or when? Consider what happened to conglomerate General Electric and retailer J.C. Penney. GE stockwas priced at close to $60 a share in 2000 but languishes in the teens today. J.C. Penney was worth $86 a share in 2007 and literally pennies (pardon the pun) in October 2020, when its retail operations were sold to two large real estate investment trusts after it had declared bankruptcy.

You just don’t know what the future holds.

BITCOIN BOING-BOING?

At least the FAANG stocks have strong track records.But what about investments like cryptocurrency?

The price of a Bitcoin was $909 in January 2017. Over the next four years, it was:

$17,099 – January 2018

$3,799 – January 2019

$7,348 – January 2020

$29,388 – January 1, 2021

So far in 2021, the price of Bitcoin has jumped upand down and back up again. After dipping to about$32,000 in late January, it reached $61,284 on March14, before sliding down a bit. (All prices are in U.S.dollars.)

BAAAAD HABITS – TOO SHEEPISH?

That’s a lot of sharp ups and downs, which can be unsettling. But what is the value of something like Bitcoin based on, other than the perception that it will rise? Or is that perception deception? It’s odd for a vegetarian like me to ask this, but, “Where’s the beef?”

That often leads some investors, or perhaps we should call them sheep, to buy stock after it rises and to sell shares after the price falls.

Perhaps there are logical reasons for the recent skyrocketing price, driven by an apparent growing acceptance of cryptocurrency among some major banks, and comments by famous people, like Elon Musk, the bold, ultra-wealthy founder of Tesla.

But much of the price rise and fall of something with no inherent value beyond what the market says it’s worth is simple speculation. Frankly, that scares the stuffing out of me. Just like buying groceries, if I’m investing in something, I want it to have some measurable value. There are no guarantees, but that makes me feel the investment is more likely to

There’s a consistency or uniformity, and a disciplined method involved. They’re not foolproof by any means, but they apply logic and math.

In contrast, to be drawn to an investment because others are excited about it seems like amplified risk.That often leads some investors, or perhaps we should call them sheep, to buy stock after it rises and to sell shares after the price falls. Buy high and sell low is not a good formula for building wealth.

A WORLD BASED ON LOGIC

I take comfort in logic, facts, and measurableestimations of worth or value.

The world of investing is supposed to be built on logic. One approach to investing is called fundamental analysis. Very simply put, it looks at the financial health and market prospects of a company and projects how much its stock should be worth, based on forecasts of its profits, or what people are paying for when they buy a share.

Another approach is called technical analysis. It uses charts and graphs to track trends in a stock’s or a commodity’s price, partly driven by demand and supply. Without drilling down into the granular detail of either approach, I appreciate these types of analyses, particularly fundamental analysis.

There’s a consistency or uniformity, and a disciplined method involved. They’re not fool proof by any means, but they apply logic and math. Those can form guardrails that keep investors on track rather than be distracted by emotions as they drive along the investment highway toward their financial goals.

Those rigors can help calm us down when we get excited, as is easy to do when we see the price of an investment rise spectacularly and we get a case of FOMO – Fear of Missing Out. It’s normal to not want to miss out on something good, especially if it’s “easy money.” Who’d wish to be left out of the party?

WARREN’S WISDOM

It might help to remember what Warren Buffett wrote in 1999, during the height of the dot-com stockbubble. It’s a long quote, but well worth reading:

“The line separating investment and speculation,which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball. They know overstaying the festivities … will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”

To cite another Buffett quote that brings home the difference between investing on speculation and purchasing groceries based on value: “When hamburgers go down in price, we sing the Hallelujah Chorus in the Buffett household. When hamburgers go up, we weep.”

Just as you would hesitate to buy groceries after they double in price, think twice about why you want to invest in a hot stock. And whenever possible in the world of investing, try to apply logic as a safeguard against the intoxication of emotions. You might just avoid one helluva hangover!