In the first four parts of this article, I have discussed a number of well-known behavioral biases that cause investors to make decisions that are, to put it kindly, less than optimal. In this final installment, I summarize how best to avoid these costly traps.
As these blog posts have been published over the past couple of weeks, the issues are much in evidence. Apple (AAPL), long the darling of the market, has lost favor and Groupon (GRPN) seems to be following a relentless downward spiral. Surely many investors in Groupon must be asking themselves how they could possibly have seen the company as a good bet. Apple stock, which was trading at $700 in mid-September, is currently at $544, a decline of 22% in two months. The news that has come out on Apple does not seem sufficient to justify such a broad shift in the market’s consensus as to the long-term value of Apple as a company. And, of course, we have the poster child of behavioral bias: Facebook (FB). How is it possible that the market’s consensus view of the share value of such a widely held company could be almost 50% below its first day closing price of $38? As Warren Buffett is quoted as saying, in the short-term the market is a voting machine and in the long-term the market is a weighing machine. When voting overwhelms weighing, investor psychology is dominating.
In this post, I continue the discussion of behavioral finance with examples of some of the key behavioral biases and where they can be seen in recent market behavior. The specific focus of this post is those biases that drive investment fads and bubbles.
It is almost invariably the risk that we ignore that really hurts us. The market today is, for the most part, discounting inflation risk. Historically, inflation has been a major threat, especially to bond investors. Today, with yields at historic lows, the implied inflation expectations are exceedingly low. The process by which the market comes up with rationales as to why a risk, that has historically done major damage, no longer matters is at the heart of every bubble. We have had the housing bubble (in which investors became convinced that houses were an infinite source of capital appreciation), the Tech bubble (in which investors decided that valuations based on earnings were irrelevant) and now the government debt bubble (in which investors are implicitly assuming that inflation risk is no concern). The bubbles get out of control largely because people assume that what has worked recently will continue to work. Continue reading →
I have not seen this type of brand name IPO trading volume for quite some time. From Groupon (GRPN) and Pandora (P) to Zynga (ZAGG) and now Avaya, the media would have you believe that investing in a brand name IPO is a quick fix for your portfolio.
Take the recent public stock offering in LinkedIn (LNKD) for example. The IPO price was set at $45 and jumped to $90 after one day of trading. As of this writing, the price is just below $73. At its current valuation, Morningstar estimates the Price-to-Earnings (P/E) ratio at 466. By comparison, the tech-heavy NASDAQ has a P/E of less than 20 (as of this writing).
Clearly, many people are very excited about the LinkedIn IPO and it shouldn’t surprise you that investors have had a long history of enthusiasm for IPO stocks. But has this enthusiasm ever paid off over the long-term? Continue reading →