Turn This Marketing Secret Into Big Returns

Have you ever bought a stock just because it went down and was "bound" to come back up? I'm talking about taking a position in a cheap-looking company because "it had to come back up." Think megabanks such as Citigroup (NYSE: C) and Bank of America (NYSE: BAC) in 2007 and 2008. Despite the banks' survival, speculators in those two companies burned themselves many times over, as prices fell, and fell again, and then fell some more. Speculators in General Motors, once the world's largest car company, were also burned, with no chance of recovering their investment.

What goes down need not come back up. But we're influenced so heavily by our own innate psychological biases that our gut instincts can often lead us away from the next home run stock. The same trick led pundits to declare that Google's (Nasdaq: GOOG) $85 IPO was expensive. I'd love to buy shares at twice that price now.

Don't psych yourself out
Consider the strategy that Apple (Nasdaq: AAPL) used when it rolled out its iPhone in mid-2007. By manipulating prices, Apple created demand for its do-it-all cell phone. When the company introduced the phone, it smartly set a high $599 price to skim profit from early adopters, who would have purchased the highly touted product even if its sole feature was the delivery of repeated and painful electric shocks. The iPhone was the next big thing, and these people intended to be the first on their block to have one -- another bias, by the way, that kills your investment returns.

But here comes the trick: CEO Steve Jobs lowered the price to $399, to skim the next layer of cream, and then again later.

How exactly is a lower price a type of manipulation? This type of pricing strategy takes advantage of our natural proclivity to engage in what's called price anchoring. Duke University business professor Dan Ariely explains:

I haven't talked to Steve Jobs about this, but let me speculate about what he did. He put this iPhone out at $600 and immediately reduced it to $400. Now, it could have been a mistake, but it also could have been a smart trick, because the question to the consumer at that time was, what is the comparison price? All of a sudden, something can look like a great deal at $400 when it was $600 just a few weeks earlier.

If Apple had introduced the iPhone at $400, it would have been a different story. But the initial $600 price and then the $400 helped, I think, create a very high price point in people's minds. And now that the iPhone is being offered at $200, it looks like a fantastic deal, because we still have these very high prices sticking in our minds.

This ingrained tendency to anchor to the first number we associate with a product has been shown time and again in scientific experiments, even though people anecdotally claim that an initial reference price has no effect on them. In fact, Ariely had a series of test subjects first record the last two digits of their Social Security numbers. Then he had them price various products. The subjects with higher Social Security digits consistently valued the products higher.

The same pricing strategy occurs in many other places:

• In restaurants, which have a few expensive entrees, so that their midpriced offerings look like a good value by comparison.
• In real estate, as home sellers increasingly anchor to much higher 2005-2007 prices.
• In the stock market, when companies split their shares to provide the illusion of a cheap stock, even though the company's intrinsic value hasn't changed.

Don't spoil your returns
Our tendency to engage in price anchoring is a portfolio killer if we allow our instinct to guide our trading actions, instead of relying on rational thought. It means the difference between finding a 20- or 30-bagger, or settling for a measly double. The problem of price anchoring is less dangerous for lumbering cash cows such as Procter & Gamble (NYSE: PG) or Altria than it is for the high-performing companies that create their own industries

If you listen to your gut when your stock reaches a new 52-week high and looks expensive (as opposed to actually being expensive), then you may sell the home run stock of the next decade.

Consider Apple's stock price on the first trading day of the year over the last decade:

Sources: Yahoo! Finance and Capital IQ, a division of Standard & Poor's.

Look back to the start of 2005. Apple may have looked expensive if you had owned it the previous year. The stock had nearly tripled – a nice annual gain. And if you had looked at the trailing P/E, you might also get the impression that the stock was expensive, trading at 50 times last year's earnings. However, the market prices stocks on future expectations. That's truly the danger of price anchoring: by looking at the past instead of examining the future, you might have tricked yourself out of more massive gains. Since the start of 2005, the stock has gone up more than six times!

The danger of price anchoring is especially acute for high-growth stocks, such as Google, Amazon.com (Nasdaq: AMZN), or Baidu (Nasdaq: BIDU). Because their future is so bright, you can't let yourself be fooled by stocks that look expensive (or cheap) on a trailing basis. You have to coolly examine the future. That's the approach Motley Fool Rule Breakers takes as the newsletter discovers companies that create their own industries.

Look forward
Ranked among the top 10 performing newsletters for 2009 by Hulbert Financial Digest, Motley Fool Rule Breakers is led by Fool co-founder David Gardner, in search of the highflying companies of tomorrow. To turn Apple's marketing secret to your advantage, David and his team extensively examine tons of companies that, like Google in 2004, get ignored by the market because of price anchoring.

When searching for a stock, David asks:

• Is it the "top dog" and "first mover" in an emerging industry?
• Does it have a sustainable competitive advantage?
• Is good management in place, with smart backing?

Take a free 30-day trial of Rule Breakers. In addition to helpful company reports, you'll also get David's top growth-stock picks for new money now and 24-hour access to a community of investors dedicated to finding the next 20-baggers.

Stick with us if you like it; pay nothing if you don't. To learn more, simply click here.

Fool contributor Jim Royal, Ph.D. owns shares of Bank of America and Procter & Gamble. Baidu and Google are Rule Breakers recommendations. Apple and Amazon.com are Stock Advisor picks. Procter & Gamble is an Income Investor recommendation, and the Fool owns shares of it. The Fool has a disclosure policy.