You’re An Irrational Stock Picker

Do me a favor.

Think of the last stock you purchased.

Actually, think of the last few stocks you’ve purchased.

If I tell you to remember just one, you’ll probably cling to the one that made you money because you get aroused every time you think about it. But, don’t forget about the one that dropped the day after you bought it. Remember? You were confused because your neighbor “who pays attention to these kinds of things” told you it was a sure thing.

Regardless of the result of your last investment, whether it went up or down, I have to ask you a question.

Why did you buy it?

What was it about this particular company that made you want to part with your hard-earned money?

Did you buy it because you thought it would go up?

I assume this is why you decided to invest. We can highlight dividends and other variables that factor into positive returns, but I assume that most amateur investors are simply in search of a higher stock price.

“And, uh…what’s wrong with that?”

My goal in questioning your last investment is to highlight how irrational your thinking is.

There’s a theory that exists called the “Efficient Market Hypothesis” which simply says that the stock market is efficient and a stock’s price reflects all available information. In other words, a stock’s price factors in everything. The belief that a company will grow three-fold is already baked into the price, making it more expensive. If a stock is paying a handsome dividend, that expectation is already baked into the price, making it more expensive. Every available figure, data, or trend that is contributing towards your “gut feeling” is already accounted for.

I don’t want this to discourage you, though, because there are plenty of holes in this theory. Thanks to psychological phenomena – such as fear, greed and the herd mentality – markets are not always efficient. An investor can often find plenty of instances where an individual stock is undervalued.

But, even though there may be an opportunity of a mispriced security, how are you determining this? Did you read through a company’s financial statements? Did you study their balance sheet? Do you know how much debt they carry or what kind of margins they enjoy? Did you like the news that the company’s CEO shared on their last conference call?

If not…

…then how can you tell me that this stock is undervalued?

Is it undervalued because it went down last week and you know you’re supposed to “buy low, sell high”?

How do you know it wasn’t overvalued before and now it’s returning to where it should be?

Warren Buffett suggests that it takes at least 6-8 hours per week to identify stock market opportunities. If you’re spending this time researching specific companies to invest in, then you’re doing well! There are definitely ways to gain from a mispriced market. If you’re buying stocks based on a “feeling” a “hot tip” rather than research of your own, you’re not investing. You’re gambling.

If you’re gambling, then admit that you’re gambling and reduce this irrational investing to just 10% of your portfolio.