Don't Let the Giffen Get You

Prostitutes introduced me to the concept of "Giffen goods." 

Wait, let me be more specific. In a recent post on the Freakonomics blog, Steven Levitt tackled the question of whether prostitutes are "Giffen goods." I was intrigued.

We're used to seeing demand for products go up when their prices fall. As makers of large-screen TVs, such as Sony (NYSE:SNE), Panasonic (NYSE:PC), and Philips Electronics (NYSE:PHG), have dropped the prices on their offerings, for example, consumers have swooped in to buy more of them. I'm waiting for prices to fall even more before I join the ranks of buyers.

But Sir Robert Giffen, for whom Giffen goods are named, argued that with some goods, consumption rises as the price rises, a phenomenon rather opposite of what economists are used to expecting. Levitt offered the example of rice.

The explanation here is that rice is often a staple for the very poor. If the price of rice rises, and there are few to no substitutes, the poor will have to spend more on this staple. Therefore, they are even less able to buy more expensive foods, like meat, and thus they have to buy more rice to complete their diet.

(For those who just have to know: Levitt concludes that prostitutes are "absolutely not" Giffen goods.)

Why am I bringing all this up? I started thinking that maybe stocks are Giffen goods -- and maybe that's a bad thing.

Chasing demand
Let me explain. Imagine a scenario where shares of a certain stock are surging. It shouldn't be hard to imagine, since it happened in force in the late 1990s, before the Internet bubble burst. Look at these high prices from the turn of the millennium, compared with recent prices:

Data: Yahoo! Finance.

Clearly, many companies' stock prices had gotten ahead of themselves. Given that, were investors stepping aside, waiting for them to come down to reasonable levels? No. They were snapping up shares, not wanting to be left out. Their purchases were, in fact, what was driving up share prices.

That seems to fit the definition of a Giffen good, as demand was increasing while the prices rose. And we can see the opposite effect in action now; demand has slacked off for many stocks as their prices have fallen.

Beware the Giffen gryphon
Foolish investors should take a big step back and look at the stock market's overall behavior. If you see yourself drawn to a stock that's surging, make sure the company's price and quality both pass muster before you even consider buying. Does the company boast healthy finances, strong management, good prospects, and competitive advantages? And is its price attractive, offering buyers some margin of safety, or has it eclipsed its intrinsic value?

If you can fight the Giffen urge, your portfolio may benefit. Oftenn, the best time to buy a stock is when others don't want it -- namely, when its price falls.