“I only bet on growth stocks”: When the market is too fearful, agile smart people can take advantage of “price distortion” to profit

Chapter 4: Bad News Creates Growth Stocks

Value stocks have another appeal: The market keeps churning out new value stocks. When a few leaders go wrong and stigmatize an entire industry, a new crop of value stocks tends to emerge.

Bad news is often overblown, and this phenomenon is certainly not limited to the investment world. What happened after the United States launched Skylab, the first manned space station, in the late 1970s is a perfect example of how investor overreaction to bad news can serve Those of us with our cool heads create opportunities. I haven’t come across any better examples so far.

After several years of orbiting in space, the space lab began to break down, and it was clear that it would fall into the atmosphere. That’s when public hysteria broke out: the media ran wild, revealing that the wreckage was a threat to the lives of all human beings. Time magazine described the looming catastrophe with a cover story. I’m pretty sure there must have been thousands of kids hiding under their beds in terror.

“Wait,” I said to myself, “journalists don’t understand odds. They hate getting numbers right.” The average person doesn’t understand statistics much better than journalists do, and we overstate the occurrence of low-probability events. Likelihood, treating an event with a one-in-a-thousand chance as an event with a one-twentieth chance. So I set out to calculate the odds that 500+ pieces of deadly debris the size of a .50 (inch) caliber bullet would fall on the 510 million square kilometers of Earth and hit 5 billion people.

According to my calculations, your chances of surviving the skylab fall are actually not too low. If these five hundred pieces of wreckage were randomly dropped from the sky, the chance of one of them hitting a human being would be about one in two hundred, and the chance of hitting an American would be one in three thousand. In fact, the US space agency (NASA) has the ability to control the approximate landing area of ​​​​Skylab, so the probability of American death must be about one in 20,000. Given that an average of 130 Americans died in car accidents every day that year, an American was 400,000 times more likely to be killed by a car than to be killed by Skylab on July 11, 1979.

Skylab did break up in the atmosphere, but the pieces fell in the Indian Ocean, the least inhabited place in the world, according to NASA’s plan. Very little debris fell on land. Perhaps a few Australian sheep were slightly disturbed, but there were no human casualties. This whole thing is a joke.

Another ridiculous example of overreaction is the Three Mile Island nuclear power plant, which exploded around the time Skylab fell. The nuclear reactor of the nuclear power plant was destroyed, but the resistance container outside the reactor was unharmed, and all the radioactive wreckage was sealed in the resistance container. The International Atomic Energy Agency noted that no radiation was detected outside the plant (unlike Chernobyl, which had no containment vessel). The media exaggerated the scale of damage at the nuclear plant, leading millions of Americans to believe that a major public health disaster was imminent.

The truth is far from it. Imagine a pair of twins living on a farm on the edge of the Three Mile Island nuclear power plant. One of them was worried he was going to get sick, so he jumped in the car in a panic and drove to Harrisburg. But another said, “Bullshit, I’ve had enough of this bullshit.” He took off his clothes and stood next to the Three Mile Island nuclear power plant all day. Who is more at risk? You can easily prove that the higher risk is the twin who drives away, because the chance of dying in a car accident is far higher than that of standing naked.

But a mixture of media and politician hysteria had an effect: the U.S. nuclear industry came to a complete halt after the Three Mile Island incident. Even though other energy sources such as burning coal, synthetic fuels, and solar energy cause different types of damage to the environment and greatly increase the chance of human death, people still oppose nuclear energy.

Nimble smarts can profit when prices distort

Scientists have thoroughly studied how people often react to real or imagined disasters. There are also some people who have published related works. For example, someone has published a book describing Orson. How Orson Welles’ radio play “The War of the Worlds” sparked panic, leading many to believe that Martians had really invaded New Jersey. But it wasn’t until the early 1980s that psychologists began to study how people respond to financial anxiety. Only then did they discover that this irrational reaction was also prevalent among investors.

Much of the related pioneering research was done by the late Stanford University professor Amos. Tversky (Amos Tversky) and Daniel now at Princeton University. Done by Daniel Kahneman. Their research confirms that most people are also prone to exaggerated responses when it comes to finances. Whenever an event is likely to happen, people are bound to worry about it, whether it’s one in a thousand or one in a million. This explains why cancer insurance, airline insurance, and other protection against disasters are so popular, even if they cost far more than they actuarially justify.

In addition to overestimating the dangers of rare and special events, people also overestimate the value of victories with little chance. Casinos, racetracks and lottery shops are always crowded. Optimistic gamblers provide steady fortunes to those who know what the true odds are.

This phenomenon also exists in the stock call option (call option). Options that are worth very little according to probability theory can be sold for more than they are worth because they are like lottery tickets. Rational investors should also avoid high-risk stocks with extremely low prices. While a $2 “good” stock is extremely cheap, that’s why it’s more likely to be an overpriced stock. In the movie “The Bank Dick” (The Bank Dick), William. Claude. The protagonist, played by William Claude Dukenfield, has made a fortune on the stock of Beefsteak Mines, but in real life, an investment with little odds is a very bad bet.

One of Tversky and Konnerman’s big discoveries was that a dollar gain and a dollar loss are not equal for most people, at least not when the stakes are high. Who would use their own car to bet on the neighbor’s car when the winning rate is not high? There are absolutely very few people who do this. After all, the disadvantages of not having a car far outweigh the advantages of owning two cars. Human perception of price is not linear, so a person will be more unhappy when he loses a certain amount of money than he will be happy when he wins that amount of money. Most people are only willing to risk high stakes when they have a two-thirds chance of winning.

If most investors do this opposite of risk, then we can understand why they would rather accept lower-yielding bonds and other fixed-income investments than stocks, and why they Stick to buying blue-chip stocks, rather than taking the risk of buying higher-yielding stocks in smaller companies. I know very well that I will be able to find buying opportunities when the probability of return exceeds the probability of risk, because most people will ignore the probability, exaggerate the risk and tend to sacrifice for the safety of the first glance rate of return.

One of the most interesting ideas in Konnerman and Tversky’s research is the role of “situation” in the decision-making process. People make different decisions depending on how the problem is presented. When the potential profit is emphasized during the transaction, people will become nervous and cautious, but if the potential loss is magnified during the transaction, people will be too scared and willing to take higher risks in reality in order to avoid losses .

For example, suppose a person spends an afternoon gambling at the racetrack, has lost $140, and is considering a $10 bet at odds of 15 to 1 on the final race. The person can describe the decision-making process in two ways, using two different points of reference. Limiting the reference point to the cash in the hands of the gambler, we can describe the outcome of the gamble by saying that the gambler could make $140 or lose $10. However, the more common point of reference is the situation where I have lost $140 all afternoon. At this time, when I describe this gambling, I will say that this wager has a chance to win back the lost money or to repay it. Add $10 to the loss.

Prospect theory (prospect theory) believes that the second description will make people more willing to take risks than the first description. As a result, people who don’t adjust their reference points are more likely to lose money and place bets they would normally find too extreme, even betting on unreliable odds of 15 to 1. The fact that the bets with the lowest odds are indeed always the favorite in the final horse race of each day confirms the above analysis.

Investors who encounter losses when investing in stocks will also have the same mentality. Unable to tell what the stock is really worth, these less fortunate investors are willing to take the long-lost bet and hold on to the stock. Even if they know that something is wrong with the company, they will eagerly hope that the stock price will recover and make back their previous losses. The stock market is not a racetrack, but we all know that investors have different behavior patterns in bull and bear markets, and constructing these theories will help us explain some of the differences in behavior.

In recent years, there has been an increase in academic research on financial behavior—more specifically, on investor behavior. For example, in April 1995, the Association of Investment Management and Research (AIMR), a professional organization of financial analysts, sponsored a symposium on behavioral finance and Decision theory (Behavioral Finance and Decision Theory in Investment Management). About five or six researchers (including Tversky, who died about a year ago), presented papers at the symposium.

In May 1996, investment managers and academics participated in a two-day seminar on “Behavioral Finance” at Harvard University. One of the points that the 1996 symposium made was that it’s easy to get led by the nose for stocks with strong growth performance and pay too much. Some people therefore believe that value investing is the superior strategy.

Recently published research has further confirmed the original conclusion: investors, like ordinary people, will not be completely rational or even in their own best interests when they encounter various events, which is consistent with the assumptions of classical economics on the contrary. Investors must of course take into account economic and corporate activity, but it’s not just interest rates and earnings per share that can affect markets and individual stocks.

A large part of the reason why the efficient market hypothesis can be established is based on the premise that “investors will respond rationally when they receive new information”. Psychologists’ challenge to the market hypothesis also fits with what investment experts have said over the past few years: Investors evaluate information emotionally, creating price distortions that nimble smart people can profit from.

When the market is overly fearful, the opportunity to buy appears

Skylab, Three Mile Island, and studies of investor psychology all reinforce an important payoff: When markets get too worried about improbable catastrophes, there are stable companies that have little chance of going wrong. , would be a suitable target for purchase. When a negative event occurs, stocks may fall more than the event should have caused. This happens so often that it has earned its name: “overdiscounting bad news.”

Opportunities to buy individual stocks can arise at any time after investors overreact. In fact, around the time of the Skylab-Three Mile Island incident, Chicago’s O’Hare Airport suffered a horrific DC-10 accident that killed aircraft manufacturer McDonnell Douglas. Douglas’ share price fell from $28 to $20. After the fallout subsided a bit, the stock was back at $26. Such heavy selling and stock price rallies are all the more common in this day and age as so-called momentum investing has grown in popularity.

Momentum managers buy stocks based solely on whether the stock price has risen recently—these managers prefer to refer to the stock’s “relative strength”—then they buy stocks when the stock price falls to a predetermined level. (You can also say that their behavior is basically buying high and selling low). Because this system can bring relatively good returns in the late bull market, it attracted a lot of supporters and funds in the 1990s. When there is bad news in principle, they are sold in large quantities at the same time, so that these stocks are easy to drop suddenly below their actual value.

Another situation that often happens is that the entire industry or industry has fallen to a price worth buying because of investors’ excessive worries. As long as investors start worrying about disaster in an industry, you can find some solid companies at extremely low prices and with very little risk.

An excellent example of this is the banking industry over the past decade or so. Large financial center banks have been in constant trouble for being willing — no, eager — to lend money to less creditworthy counterparties (“aggressive bankers,” in my opinion, should be ambivalent rhetoric, like “active mistress”.

Between 1982 and 1983, U.S. banks’ foreign debt to foreign governments made headlines. Banks keep issuing new debt to perpetuate old outstanding debt from governments including Argentina, Brazil, Poland, Say, and Mexico (we worried about Mexico defaulting in the first quarter of 1983, then we did in 1995 Fear of Mexico defaulting again in Q1. Same old problem tends to come up over and over again). Compounding the situation, in addition to government defaults and refinancings, were dodgy loans taken out by embattled real estate developers and smaller loans taken out by leveraged buyout firms.

Banks in big cities have these problems, no doubt because they are asking for it. But small banks in Wilmington, Delaware, or Honolulu, Hawaii, don’t lend money to foreign governments, and they’re very cautious about real estate lending, but they’re still caught up in the indiscretions of big international banks. swirl.

These small banks are undervalued. We bought quite a few of these banks (after making sure, of course, that they were run by bankers, not tailors – see next paragraph). We realized that sooner or later these investors were going to pay for these low P/E bank stocks, and we were proven right because of the very question I asked Acorns shareholders: “Wait until these How can investors continue to maintain such a low stock price after seeing the price-to-earnings ratio?”