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Why is buying a rising stock so hard?

January 15, 2013 | About:

The famous value investor adage is “I always buy too early and sell too early.” Basically, value investors are saying their timing is horrific- they always miss the market lows and highs. Of course, there is also a bit of ego in that statement: the saying also implies that the investor recognizes opportunities before the market does and sells them before the market realizes they’ve turned bad.

But I personally think thing value investors are worst at is buying a stock as it moves up. Even Warren Buffett has this problem, as you can see with this quote on not buying Walmart because of a small rise (I believe he also mentioned it in one of his annual letters, but can’t remember off the top of my head).

Why is this so hard? The reason is pretty simple and rooted in behavioral economics- investors tend to anchor on prices. If we started buying a stock at $5, we believe the stock is worth $5 (or, as a value investor, hopefully you think it’s worth $10+ and are buying it for a discount!).

As a value investor, your impulse (hopefully) is to think a stock is a screaming bargain when it goes down w/ no new news. When a stock goes up, your impulse is probably to be a bit wary, start checking your price targets, and consider selling for something that has been going down and is cheaper.

So the big problem comes when stock prices change and there is new news.

Investors anchoring on the price they paid and refusing to sell until they have a profit, even in the wake of deteriorating news, is a well known bias and has been discussed frequently.

But I personally think this is much, much less of a concern for deep value investors. In the absolute, if you were running a pure net – net strategy with tons of diversification, it would probably serve you best to completely ignore any poor news and only sell when stocks were no longer net-nets, even if their news and fundamentals were rapidly crumbling (note- this is the reason I’ve determined to hold onto SPCO in the wake of declining sales and fundamentals).

Why? Because net-nets are generally net-nets because they have crappy fundamentals and news, which is why you can buy them at such a discount. (See this excellent article over at greenbackd for more of a discussion of why crappy fundamental net nets will probably outperform net-nets that have more positive fundamentals. Greenbackd also wrote a new book, which is getting stellar reviews.)

I think the bigger challenge for investors is to buy a rising stock when it becomes cheaper despite rising.

I personally have two recent examples. I started nibbling a bit at Autoinfo (NASDAQ:AUTO) in the mid 70s. In fact, I wrote it up for a newsletter I run (the reason it was never on the blog is I keep a three month lag between writing the newsletter and posting about stocks on the blog), and I had some limit orders out there to pick up a bunch of shares that just kept getting missed. Then this article came out and the price ran up to the mid $0.90s.

Now, given the growth the company has experienced in the past nine or so months, plus stock prices of competitors, the stock is probably as cheap or perhaps even cheaper than when I first started trying to pick up shares. But my mind is anchored pretty hard on that $0.7 handle. I just can’t bring myself to buy after this big run up.

Another example is JCTCF (another newsletter pick which I ended up writing up). I’m going to talk about this a bit more when I review their earnings later today or tomorrow, but I started picking up shares in the $8s. I set out to make the stock a huge position of mine, but it proceeded to run up to the mid $9s. Even though I pegged it’s value at over $15 a share at the time, I stopped buying. Why? I have no idea. I just sucked my thumb, hoping the price would come down.

Fortunately, after the stock sat there for a while, I came back around and started buying in the $9s. But when the stock ran to the $11-12 range, I sold a huge block. At the time, I was pegging IV around $18. Why did I sell then? Again, I have no idea.

Today, the stock is at $15. I’d peg IV at $22 minimum. And while I’m not selling shares, I’m not buying more either. Why? I keep thinking about those shares I sold in $11′s. And those shares I didn’t buy in the $9s. And I can’t bring myself to buy at these levels.

Is there a solution to this problem? Unfortunately, I don’t know. Investors also tend to ascribe positive feelings to stocks that do well and negative feelings to stocks that do poorly.

How can an investor decide when to buy more shares of a rising stock? How do they know they’re doing so because they’re still receiving a proper margin of safety, and not because they fall in love with the stock simply because it’s rising?

Food for thought. I wish I had a good answer for you. But if Buffett can’t figure it out, I probably can’t either!

Disclosure- Long AUTO, JCTCF

Rating: 3.6/5 (7 votes)



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