Today, I'm introducing a new concept in behavioral finance.
I call it the "Thrift Shop Fallacy." It's a dangerous phenomenon...
This bias causes newbie investors to throw money into the wrong stocks. It leads to missed opportunities... and, even worse, money down the drain.
The study of behavioral finance helps explain why investors act irrationally at times. As you know, investors are often guided by their emotions.
A popular example in behavioral finance (and the world at large) is "confirmation bias." This is when folks actively seek out information that supports their beliefs.
If someone is bullish, for example, he or she may only look for data points suggesting that stock prices are going higher. Such folks tend to ignore signs that markets may head lower. Their thinking becomes distorted.
Selectively choosing which information to use can lead to a lack of diversification in your portfolio, leaving you unprotected when markets turn.
The Thrift Shop Fallacy – again, that's what I'm calling it – is when investors are irrationally attracted to stocks with lower share prices over stocks with higher share prices.
I call it the Thrift Shop Fallacy because so many people flock to secondhand stores because of the low prices. People think they're going to pay $2 for a watch that's really worth $50... but that $2 watch is usually just a $2 watch. It's the illusion of a bargain.
Cheap stocks have a similar pull. Here's what I mean...
Let's say I offered you $1,000 to invest in one of two stocks: Stock A costs $25 per share, while Stock B costs $500 per share. With $1,000 to spend, you could either buy 40 shares of Stock A or two shares of Stock B.
For this example, both stocks are in the same industry, sell similar products, have the same market capitalization, and have roughly the same results financially.
The vast majority of investors would choose Stock A.
Just to prove my point, I sent this question to members of our Stansberry Research support staff. The overwhelming majority of them said they wanted to buy Stock A instead of Stock B.
As one employee put it, "As a beginner investor, I would select stock A. More shares the better!"
This is how most of us think... It sounds like a better deal to own 40 shares of something rather than just two.
We all have egos. It's hard to impress your buddies if you just own two measly shares. In your head, you seem like a less serious investor. Owning 40 shares of a stock makes you feel like your investment is bigger than it is.
Also, our brains are wired to think Stock A has a better shot at moving higher than Stock B. Several folks from my survey chose Stock A because it had a "bigger potential return."
For whatever reason, an investor can imagine a $25 stock moving to $50 more easily than a $500 stock moving $1,000. Both stocks double in value and their returns are the same. But most folks are able to process things better when smaller numbers are involved.
Think about it this way... We've all looked for stocks trading for less than $10 per share. If you happen to find one trading for $5 per share, it's easy to say, "If it only goes up by $1, I'll make 20%." But when you own a stock for $500, it's rare that you find yourself saying, "If it only goes up by $100, I'll make 20%."
A company's value is measured by its total market capitalization, not its share price. And investors measure share-price moves by percent changes, not dollar figures.
You can witness the Thrift Shop Fallacy in action after a company decides to split its shares...
A "stock split" is a corporate action in which the number of shares in a company increases while the price of that stock decreases by the same multiple. Here's an example...
If a company announces a 4-for-1 stock split, the shareholder will get three additional shares and the price of the original shares will be divided by four. If the stock was trading for $400 a share before the split, it would trade at $100 after.
Many investors will think the shares are a more attractive investment when they trade for $100 instead of $400.
That's just not true.
Again, a stock trades based on its market cap, which is the number of shares outstanding multiplied by the share price. After a stock split, nothing changes about the company fundamentally. Splits don't alter a company's value.
It's a mistake for an investor to buy a stock simply because its shares have become cheaper. If you didn't like the stock when it traded for $400 a share, you have no reason to like it when it trades for $100.
If you ever find yourself getting sucked into the Thrift Shop Fallacy... go back to the fundamentals. Look at the stock's valuation, its margins, its opportunities for expansion, and its moat. Get notions of price change out of your head.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig
Editor's note: Doc has been in the financial markets for more than 40 years... And he rarely comes out with big announcements or predictions. But right now, he says we're on the verge of the biggest shock to the U.S. retirement system that he has ever seen.
On July 19, he's coming forward to show you exactly what's going on... how to prepare for it... and how this development could help you compound your wealth by 20% per year or more in some of the lowest-risk assets on earth.
We're confident this story could have a bigger impact on your wealth and your overall well-being than anything else in the next decade. Learn more here before July 19.
"Buying the dips works – right up until it doesn't," Dan Ferris writes. With no clear end in sight for today's market downtrend, novice traders are primarily targeting cheap stocks. But history shows buying stocks strictly when they're trading at a discount could lead to catastrophic losses... Learn more here.
Investing in underrated stocks that are trading for cheap can help you earn solid returns. But it's crucial to understand the difference between a great find and a "value trap"... Read more here: When a Value Trap Turns Into a Value Play.