Shares in Facebook (Nasdaq: FB ) look cheap from where I'm sitting. Since opening at $42 in the middle of May, they've plunged an astounding 45% and are trading at a little over $23 today. Certainly they must be a buy at this price, right?
Well, not so fast. If you've been tempted by this rationale, as we all have at one time or another in our investing careers, it's important to recognize that, as the old saying goes, looks can be deceiving. Sure, there's no denying that shares in the social-media giant may be cheap, but they aren't so simply because they're trading for almost half the debut price.
Committing arbitrary coherence
In an experiment a few years back, researchers at MIT set out to prove the existence of a cognitive bias known as arbitrary coherence. The basic idea is this: Even if the initial price of something is completely arbitrary, once that price is imprinted on our minds it will shape not only present prices but future prices as well.
The structure of the experiment was simple. At the beginning of an undergraduate marketing class -- at MIT, mind you -- a researcher asked each student to write down the last two digits of his or her Social Security number. The students were then asked to bid on a bottle of ostensibly fine wine. The researchers were trying to determine whether the arbitrary act of writing down the last two digits of their Social Security number would influence the amount they'd spend on a bottle of wine.
What do you think? Certainly students as smart as those that attend MIT wouldn't fall for this trick, right? Wrong. The students with Social Security numbers ending in 80 to 99 outbid those with digits between 1 and 20 by an astounding 216% to 346%!
And lest you think that Yours Truly is immune from such bias, I recently succumbed to it as well. For two years, my wife and I had been looking at a specific painting in a nearby art gallery and wanted to purchase it as a memento of our time living in Washington, D.C. Not knowing the price, we resolved to pay no more than $350 for the picture. Yet after discovering that its listed price was $600, and negotiating to buy it for $400, we thought we had gotten away with highway robbery. In other words, we were happy to have paid $50 more than we had originally set out to. How fickle our minds are!
Invest, don't speculate
To get back to the point, then, as an investor you should never decide to buy or sell a stock simply because of some relationship between its past and present prices -- or any other price or random number as the case may be. That's called speculation and will only bring you grief and tears down the road.
The post-IPO experience of Groupon (Nasdaq: GRPN ) provides a textbook example. Approximately two and a half months after shares in the daily-deals site opened at $28, they were trading for a measly $20, down nearly 30%. Yet had an investor, suffering from arbitrary coherence, bought in at the time thinking the shares were cheap, his or her investment would be down an additional 65% today.
And the same can be said about Netflix (Nasdaq: NFLX ) . Sure, the stock looks inexpensive after tanking last week following the company's weak outlook for net subscriber additions during the current quarter. But don't forget, it's down an astonishing 80% since the middle of last year, and it could still descend further. Remember, just because something has gone down quite a bit, it doesn't mean it won't continue to fall further.
Instead of excessively focusing on price, in turn, concern yourself with a company's future earnings prospects and current valuation -- though again being wary of the pernicious influence of arbitrary coherence. In the social-media space, for instance, it's relevant to note that Yelp (Nasdaq: YELP ) has yet to turn a profit while LinkedIn (Nasdaq: LNKD ) has. This likely goes a long way toward explaining why the latter is up over 10% since debuting in 2011, while the former is down 16% since its listing earlier this year.
A much better alternative to Facebook
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