We are all very rational… at least we like to think so. At times we think things through thoroughly before making a decision. Other times we make snap decisions based on whatever. We drive out of our way to save a couple of dollars on a small item and then drop $10,000 on a stock we researched for ten minutes.
The CFA Institute recently polled over 700 investment professionals asking which behavioral bias affected investment decision making the most (see chart to the right). Herding is the tendency to mimic the actions of a larger group. Conventional wisdom often leads us to buy the very expensive and sell the very cheap. Another behavioral trait that leads us astray is confirmation, the idea that we focus on the stories that confirm what we already think.
We have often said that the stock market is only indirectly related to economics. Stock prices are a function of human fear, greed and apprehension all overlaid on a business cycle. We are sometimes rational and sometimes just a ball of emotions. The Harvard Business Review (HBR) recently did an article on decision making, summarized below. Some decisions are best made calmly, measuring all the pluses and minuses. Decisions like whether to go to graduate school or how the oil and gas sector might look ten years out, would qualify here. Your gut might be the best when you are in a situation involving previously learned protocols, like firefighting, flying, or sports.
Then there are decisions where we default to heuristics or mental shortcuts. How does this play out in the investment arena? Let’s look at Apple (AAPL – $114), the world’s most valuable company. The Apple iPhone is so ubiquitous you might think it has been around a long time. Actually it was introduced less than ten years ago, in June 2007. But what a ride it has been for Apple shareholders. The stock has gone from $17 in 2007 to $114 today, a 600% increase. And the Bulls say Apple is still selling at a moderate valuation (13x earnings versus a market multiple of over 15x) and with only a 15% share of the global smart phone market. So plenty of room left to grow.
But the Bears say, the smart phone market will eventually slow and there is a lot more competition coming in all the time.
Many professional investors who might have been skeptical about Apple have thrown in the towel. The logic goes like this: Apple has done well, it’s the biggest company in the world, it’s on everyone’s lips and in everyone’s portfolio, so it had better be in mine. The fact is the herd may be right on this one. Apple may continue to grow rapidly. The important thing to remember however is that the herd usually takes conventional wisdom further than it should, and misses the signs of change.
We are not exactly sure where Apple should sell. We are betting the right price is a lower price but the lesson is to always question the herd’s judgement and not just read stories that confirm your own opinion. Think for yourself.