My mom tells the story of a painter she knew. He was passionate -- creating art was all he wanted to do. He painted abstract landscapes for 10 years and tried to make a business out of it, but he was never able to sell enough to make a living. Just as he was ready to give up, in desperation, he decided to change his prices. Suddenly, his volume skyrocketed. Everyone wanted his paintings, and he achieved his lifelong dream.
What was his secret? He increased his prices by 10 times. Higher prices gave people confidence that his landscapes weren't simply the finger paintings of some demented bohemian freak. Higher prices implied higher quality, and it increased demand.
Are people that stupid?
What does that have to do with investing? Well, you see the same sort of thing in the market. People believe that if a stock is trading at a particular price, it deserves to be trading somewhere near that price. In other words, the price of a stock has a huge psychological impact on our perception of the value of that stock -- and it really shouldn't.
Suppose I have a $20 bill, and my inebriated brother decides to pay me $100 for that bill. I, of course, will quickly take him up on the offer. But that won't make me decide that the other three $20 bills in my wallet are somehow worth $300. Their intrinsic value is unchanged by my brother's questionable money-management decisions.
For a stock example, consider Google
This psychological error happens constantly in the market and perpetuates bubbles. If you wonder how, in 2000, Nortel Networks
Close to home
Interestingly, this issue also has an impact on our Motley Fool Inside Value newsletter. The newsletter uses strategies that hugely successful value investors have used to outperform the market for decades. We put piles of thought into every stock pick, carefully filtering through hundreds of stocks to find the ones that will provide the maximum return for the least risk.
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It is, except that fewer than one in 1,000 people takes us up on the free trial. My belief is that because we're offering it completely free, its perceived value is low. As a result, readers are willing to completely ignore an opportunity to see our best analysis and identify outstanding investments. It's a simple psychological mistake that could cost them tens of thousands of dollars.
Avoid the problem
So how do you avoid the mistake of allowing price to affect your perception of value? First, before investing in a stock, work out what that company is actually worth. If you have a rough idea of the fair value of a company and then buy below that price, you're not only giving yourself a huge upside but also providing a safety net if something goes wrong. If your calculations show that the stock is overpriced, just don't buy it.
Valuing a stock may sound tricky, but I believe anyone can learn how to do it. Anyone can go to Fool's School and learn the nuts and bolts of valuation. Or you can take a free trial to Inside Value, access our online course, and use our discounted cash flow calculator to work out the numbers.
A second way to avoid this psychological error is to view analysts' estimates with a jaundiced eye. If their estimates of a company's growth seem unrealistically high, then don't believe them. In such cases, there's a decent chance that the estimates are a psychological mistake by the analysts, justifying an overpriced stock.
And when some Wall Street big shot spews the line "traditional valuation metrics do not apply," interpret their words as "the stock's way overpriced, but I don't get paid for making sell recommendations, so I'm writing fiction instead."
Exploit the problem
Once you have a handle on this error, it's possible to take things one step further by not simply avoiding the mistake, but instead exploiting it. Just as this issue results in people overvaluing bubble stocks, it also encourages them to significantly undervalue cheap stocks. And when you recognize this phenomenon, you can profit from it.
Think back to 2000 again. Tech stocks were as exciting as your first date and as expensive as your first marriage. But the spotlight on tech made people believe that those stocks were worth their prices and that the cheap companies in the market deserved to be cheap. Nothing could be further from the truth, and if you paid attention, there was money to be made.
Take SunriseSenior Living
Dividend-paying stocks like real estate investment trusts (REITs) were equally misunderstood. VornadoRealty
Almost everyone is prone to believing that price is reflective of value, but this mistake can cost you dearly. It can leave you vulnerable to risky, overhyped stocks and prevent you from recognizing a bargain when you see it. To reduce the impact, focus on really understanding what a stock is worth, and cut through all the hype.
And if you're the type to recognize a bargain, we're still offering that free trial to Inside Value to anyone who's interested. To take us up on the deal, click here.
Fool contributor Richard Gibbons, a member of the Inside Value team, has many more psychological problems than can be expressed in a single article. He no longer has a position in any of the companies discussed in this article. Health Care REIT is a Motley Fool Income Investor recommendation. The Fool has adisclosure policy.