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Why do smart people make stupid (money) mistakes? That's one of the questions I've been asking myself constantly as I witness the episode of mass lunacy that is the Facebook (Nasdaq: FB ) IPO. Thankfully, behavioral economics provides some answers that standard economics can't. Here are three psychological biases that have manifestly driven numerous investors to buy Facebook shares (or to consider buying them today). Buyer beware!
Mistake 1: familiarity bias ("buy what you know")
Familiarity bias pushes people to favor investing in companies with which they have some degree of, er, familiarity. Here's an egregious example lifted from recent headlines: Chesapeake Energy employees' retirement-fund assets were invested in the company's stock to the tune of 38%.
At the end of March, Facebook had 188 million users in the U.S. and Canada. Given a combined population for both countries of 350 million, that means the odds are better than one-half that you are one of them (in fact, they may be significantly higher since you're reading this on the Web). There are few companies I can think of that have come public in recent memory with that sort of brand awareness and mass user appeal (Google (Nasdaq: GOOG ) and Visa are the two other best examples I can come up with within the past decade).
Many people use Facebook and they enjoy it; it's no surprise, then, that the level of interest from individual investors for Facebook shares was, by all accounts, unbridled. But blindly following Peter Lynch's recommendation to "buy what you know" isn't a prescription for success. I have to agree with Eric Savitz, when he wrote in Forbes on March 12:
"While Fidelity's Lynch was no slouch in the stock-picking game, I'd advise you to know what you buy instead of buying what you know. What I know is this: There is simply no logic to paying 100 times earnings for Facebook when there are far cheaper bets on the future of the digital economy."
Mistake 2: anchoring ("that number there!")
Anchoring is a form of bias where beliefs rely heavily on one piece of information, perhaps because it was available first, and are not sufficiently adjusted afterward. ("Behavioral Finance: Quo Vadis?," Journal of Applied Finance, Fall/Winter 2008.)
What are Facebook investors anchoring on? I suspect many of the investors who bought the stock in the days following the IPO and many who are now thinking about buying the stock are anchoring on the IPO offer price (or the first day's closing price, which was nearly identical).
The reasoning goes something like this: "It was priced at $38, and I've got the opportunity to buy it at better than a 20% discount relative to that level. Bargain!" And that would be entirely sensible reasoning ... if the people who adopted it had verified that Facebook shares were fairly valued at $38. The trouble is that, far from representing fair value, the IPO offer price flagrantly overvalued the business, to such a degree that a 20% discount hardly puts a dent in it.
On the Sunday that followed the IPO, I wrote that "a prudent speculator would require a wide discount to even the bottom of the IPO's pricing range [$34]." I stand by that statement, and I'll be a bit more specific: By "wide," I mean something along the lines of 50%. Apply that to $34, and you can start looking at the stock when it hits $17. Even at that price, it would remain speculative.
Mistake 3: disposition effect ("it's not a loss if I don't sell")
Congratulations -- you were part of a historic IPO when you bought shares on Facebook's first day of trading! You paid somewhere between $38 and $45 for your shares, and now you're sitting on a substantial unrealized loss, and you just can't bring yourself to eat the loss by selling your shares.
You're not alone. In falling prey to the disposition effect, investors are much less willing to realize losses than gains. Roughly one-third less likely, in fact, if we go by a study by Professor Terrance Odean of University of California, Berkeley, who looked at the trading activity between 1987 and 1993 of 10,000 households with accounts at a large discount brokerage.
A stock's long-term performance starting from any given point in time – which is what any genuine investor should be concerned with -- is independent of whether the stock is a profitable or losing position in your portfolio. If you own Facebook shares, the only thing that should dictate your decision today to sell, hold, or buy more is an assessment of the shares' likely future performance.
Know yourself before you consider buying Facebook (or any other) shares. If you are looking for exposure to social media, one company has been executing brilliantly on a business model that is far better established than Facebook's. Find out why our senior technology analyst says Forget Facebook -- Here's The Tech IPO You Should Be Buying. This report is entirely free of charge and available for a limited time only, so claim your copy today.