Suppose you decide to treat yourself to a sporty new car. After some research, you settle on a Mustang -- a bright red GT model, with a V8 and racing stripes. Six months later, the car has proven to be reliable and fun to drive, but something weird keeps happening: Strangers keep offering to buy it.
Even weirder, they aren't offering you much money for it, and the offers are getting lower and lower over time. After six months of ownership, they're down to barely half of what you paid for the car in the first place, way beyond any reasonable rate of depreciation. The car still smells new inside, it's needed nothing more than an oil change, the paint gleams, and gas prices haven't soared in the interim -- but you keep getting these lowball offers from strangers.
Would you sell your nice almost-new car for half of what you'd paid and cut your losses? You'd probably call me crazy for suggesting it. But what if I wasn't talking about a Mustang, but rather shares of its maker, Ford
Well, now, that's different
It's one thing to resist lowball offers for a car -- its value is easy to see and understand. Unless you're actively looking to sell, you don't follow the ups and downs of the used-car market. But with a stock, today's price is the most easily accessible indicator of value. Even if your analysis of a company's prospects suggests to you that it's undervalued, it's hard for many of us to keep believing in our analysis, and to hold when the herd is going in the other direction -- making those lowball offers for your stock.
And the worst part is, those lowball offers make many people more likely to sell. As I mentioned recently, most people hate losses more than they like gains -- about twice as much, according to research. Combine that with the speed at which market drops tend to take place, and you see lots of panic selling -- people cashing out to avoid the pain of further losses.
Selling because everyone's selling
Want an example? Take Ford again. Its price is down 15% since the beginning of July, despite reporting a surprise profit -- its first in two years. If anything, Ford's fundamental picture is better than it was a month ago, but the price has been clobbered, along with the share prices of hundreds of other companies.
Why? Well, we could argue that it's all about the subprime crisis. The well-publicized failure rates among subprime mortgages have hurt everyone from mortgage-trading hedge funds at Bear Stearns
Ignoring the herd
If you find yourself tempted to sell during a market swoon, stop and ask yourself a few questions: Has the story behind this stock changed? Are the company's long-term prospects now in doubt? Remind yourself why you bought the stock in the first place, and ask yourself whether that reasoning is still valid -- regardless of what the CNBC talking heads are saying. If it is, don't sell.
And never forget that market swoons happen from time to time. As Benjamin Graham famously said, Mr. Market is a manic-depressive fellow. When he's happy, prices go up. When he's depressed, they go down. These swings don't have anything to do with fundamentals, but too many people still buy when prices are up and sell when they're down. If you want to make the big bucks, don't follow the herd.
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