One of the great things about advising the Motley Fool Hidden Gems newsletter is that I have the opportunity to talk with subscribers about investing questions they have. Some of the questions get asked so often that it makes sense to publish the response so everyone can benefit.
Here's one common question: You buy a stock, you love it, and you love the price. Sadly, the market fails to recognize your pure genius and knocks the stock price down further. At what point do you buy more? Should you wait for a 10% drop, 20%, 40%? There must be a certain percentage drop at which you should buy more, nearly automatically. Right?
Price doesn't matter. Value does.
Actually, the answer is no. One of the more common mistakes investors can make is anchoring decisions based on their original purchase, or, if they're purchasing, on the original price at which they saw the company. I wrote about this in July 2005 in an article titled "Nobody Cares What You Paid."
There are few mental errors more widespread than anchoring. At the Berkshire Hathaway annual meeting in 2004, Warren Buffett said of his experience buying Wal-Mart
It cost us about $10 billion. I set out to buy 100 million shares, pre-split, at $23. We bought a little, and it moved up a bit, and I stopped buying. Perhaps I thought it might come back a bit -- who knows? That thumb-sucking, the reluctance to pay a little more, cost us a lot.
Buffett anchored on a price, and it was costly. (Given Berkshire's long-term returns, I assume that most shareholders join me in forgiving this little misstep.)
But that's when the price is going up. The question at hand is what to do when the price has dropped but nothing else has changed. My answer is that it is a buy anywhere from slightly above the purchase price to as far down as it goes. After all, if it was a buy at the higher price, why isn't it a buy now? And if that was the case, why isn't any price below where you originally considered it a bargain a great price?
The stock market, with the possible exception of the housing market, is the only place I know of where people are routinely more afraid of buying something when it drops in price. The fear of having a stock get even cheaper is so great that investors have been known to look right at great companies trading at great prices, only to shy away. In March, one of my Hidden Gems recommendations, Dawson Geophysical
Buy when you can
Our philosophy tracks that of investing legend Shelby Davis. When asked what was the best time to buy stocks, he said simply, "When you have the money." He turned a $50,000 grubstake into a fortune approaching $1 billion by doing things like not particularly worrying about the direction of stocks. He lost more than a few dollars when he guessed wrong, but these losses were completely outweighed by his penchant for buying great companies when the market was terrified.
In fact, not only do we try not to focus on whether a stock has fallen from our purchase price, but we don't even particularly care if it has risen as long as the company's prospects remain undervalued. Tom Gardner has recommended Ctrip.com
It doesn't always work out, of course. But by not worrying about what our original price was, we have the ability to focus instead on the prospects of a Wal-Mart or an Advanced Micro Devices
This article was originally published on Jan. 10, 2006. It has been updated.
Hidden Gems recommendations are beating the market (as measured by the S&P 500) by more than 20 percentage points since inception in July 2003. You can view all of our picks (as well as everything ever published in our pages) for free with a 30-day guest pass. Did we mention it's free? Click here for the details.
Bill Mann is the co-advisor of Motley Fool Hidden Gems. He owns shares of Berkshire Hathaway. Wal-Mart is an Inside Value recommendation. The Motley Fool is investors writing for investors.
