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.
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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.