Will Your Stock Hit Rock Bottom?

Figuring out what you believe to be the intrinsic value of a stock is one of the most significant things you can do. If you bought shares of Sprint Nextel (NYSE: S  ) for more than $10 a pop, you better know at what price you'd be willing to sell, or you may find your stock hitting rock bottom.

How you define the floor
When investors try to determine a sales price, it seems as though we all too often let our emotions get the best of us. To illustrate this point, consider an experiment documented by behavioral economist and professor Dan Ariely.

Duke students are fanatical about their basketball program, and they illustrate their passion when it comes to buying tickets. There is a strict procedure where students have to camp out intermittently for an entire semester, responding to arbitrary bull horns and missing classes and exams. These are die-hard fans. For big games, students at the front of the line aren't even guaranteed a ticket -- only a spot in a lottery system. A list is posted later with the winners of the lottery, and often those who have sacrificed the most find themselves without a ticket to the game.

Duke professors wanted to conduct an experiment, so they found students who received lottery tickets and those who did not, and tried to find an equilibrium price where a ticket could be bought and sold. Remember -- both sets of students missed classes, spent evenings in tents, and went through the same rigorous process to obtain these cherished tickets. When the lottery losers were asked how much they would pay for a ticket, the average price was $175. The lottery recipients, on the other hand, would not sell their tickets for anything less than an average of $2,400! How could there be such a price discrepancy when both sets of students were willing to go through the same ordeal?

We all love what we have ...
The reason is that the lottery winners were victims of ownership bias; that is, they overvalued what they owned, simply because they owned it!

This helps explain why people may have held on to shares of Cisco Systems (Nasdaq: CSCO  ) or Yahoo! (Nasdaq: YHOO  ) , even when the dot.com bubble was bursting at the seams. Or why people were still holding onto financials like Bank of America (NYSE: BAC  ) in 2007, when the subprime crisis was all but written on the wall.

When investors make a purchase, what Ariely calls an emotional chasm is formed between the "old you" who didn't own the stock and the "new you" who now owns some very precious shares. In the case of Duke basketball, it was an "empirical chasm as well -- the average selling price (about $2,400) was separated by a factor of about 14 from the average buyer's offer (about $175)," Ariely wrote in his book Predictably Irrational.

I fall prey to this bias every time I buy a stock. In August of last year, I purchased shares of General Electric (NYSE: GE  ) when it was trading for about $11 and change. Because there is constant controversy surrounding a conglomerate like GE, I find myself ignoring criticisms of the company or critiques about GE's capital division -- just because I own the stock. I constantly have to remind myself to step back, impartially evaluate the company, and reassess my prospects for the industry. The stock eventually fell as low as $6 (though it has since recovered to $16).

And we never want to let it go ...
Say you were bullish on the solar industry and owned shares of First Solar (Nasdaq: FSLR  ) and Suntech Power (NYSE: STP  ) , and analysts were coming out with negative industry reports. Instead of listening to the scrutiny and reading the reports, many investors would simply ignore the contrary opinion and convince themselves that their original analysis was correct. Because if in fact the analysts were correct -- and the solar industry was doomed -- then you'd have to sell your shares, and we've already established how we feel about things we already own. We simply don't like to let things go, whether it's a basketball ticket or a share of stock.

That's why at Motley Fool Stock Advisor, we don't just offer stock picks -- we also let you know when to hold or sell that stock, because -- let's face it -- conditions change. David and Tom Gardner, co-founders of The Motley Fool, offer you two stock picks every month and frequently offer updates to their recommendations. Not only will you benefit from their expert advice -- their recommendations are beating the S&P 500 by more than 50 percentage points on average -- but you have a team of analysts and a community forum to help you make the right decisions. Remember, there's no greater way to avoid having your stock hit rock bottom than having received objective analysis and reasonable advice.

If you're interested in seeing the 10 stocks Tom and Dave think you should buy right now, in addition to learning from their buy, hold, and sell analysis -- you can be a guest of the service, free for 30 days. Click here for more information.

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Jordan DiPietro owns shares of General Electric and First Solar. Sprint Nextel is an Inside Value pick. First Solar and Suntech Power Holdings are Rule Breakers selections. The Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (27)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 22, 2010, at 4:28 PM, DCTsabar wrote:

    Jordan - also remember long-term holding (or buy & hold). GE is generally a good company and is not going anywhere. The fact that they made some bad decisions in the past decade doesn't negate that in my opinion. Every company makes mistakes (e.g., and Windows Vista). The difference between a good company and a bad one is how fast they recover from their mistakes. Immelt is on the right track by downsizing GE Capital and reorganizing GE's industrial unit. 2010 will be a true test to GE's true historic nature, which is a well managed company with ever-changing and great products. Plus, what competition do they really have? So, I would suggest holding on to it.

    Have a good weekend!

    dctsabar

  • Report this Comment On January 22, 2010, at 5:24 PM, TMFPhillyDot wrote:

    @DCTsabar,

    I totally agree. It's hard sometimes to ignore the criticisms, especially when GE is posting losses. But you are right -- when you dig deeper, you see that they are restructuring GE Capital, equipment sales are up, etc. Definitely a long-term hold for me.

    Thanks for the comment!

    Foolishly,

    Jordan (TMFPhillyDot)

  • Report this Comment On January 22, 2010, at 5:32 PM, djkumquat wrote:

    GE doesn't have competitors?!? what about siemens or honeywell? or all those other players in the capital biz?

  • Report this Comment On January 22, 2010, at 9:19 PM, gregc8080 wrote:

    I see a fundamental flaw with the Duke University analogy. They state the average price that a person would be willing to pay for a ticket, and the average price that they would be willing to sell a ticket for. However, the market doesn't buy and sell securitys based on averages, the current ask price is the *lowest* price that a seller would be willing to accept, and the current bid is the *highest* price a buyer would be willing to pay. I'd like to see the range of selling prices and the range of buying prices on those Duke tickets.

    Consider that college students vary greatly in the money they have available to them. There are students from rich familys with lots of extra cash and students on scholarships with very little cash to spare. The students camping out and missing classes and tests are likely not only the poorer students, they're also not neccessarily the die-hard football fans, but the students who know they can sell a ticket to a richer student if they win the lottery. Conversely, the richer students arn't camping out in tents because they know they can go buy a ticket for $2000 or so if, when, they want to go to a game. The people who camped out and didn't win a ticket arn't about to buy one, because they never had the funds in the first place, but have the attitude of "Hey, if I could get my hands on one for cheap, sure I'll buy it, I'd like to go to a game". But the ones who *do* win a ticket arn't going to let it go cheap, because they know that there *are* the rich students out there that *are* willing to plunk down $2000 for a ticket. So the ticket really does have a value of $2000, regardless of what the "average" might be. The average simply isn't relevant.

  • Report this Comment On January 19, 2013, at 7:43 PM, AEHvalue wrote:

    Still, the tenets of this article speaks loudly to those willing to listen.

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