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"The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions."-Seth Klarman

Every investor I've ever known, has, at one time or another, told me that they often know they should buy or sell a stock, but just couldn't get around to acting. It was as if an invisible force was getting in their way.

A very important step in becoming a better investor is to understand how psychology influences our decisions.

Let me start out by stating that I'm not a psychologist. My training is in statistics, analytics, logic and mathematics. Psychologist use their understanding of human nature to provide the WHY in people. The best I can do is explain HOW they are likely to act, based upon observations. Though the WHY will always be a curiosity to me, the fact is that the HOW is what's important if you are looking for actionable investment information.

I need to mention that whenever observation is involved, we deal with the proverbial Bell Curve. This simply means patterns emerge that will apply to an overwhelming majority of situations, but there are extremes that will count fewer in number.

So, let's start with a study that was conducted many years ago. In the study, a group of college students were given ash-trays and asked how much they should sell it for. An ashtray was picked for two reasons... it had no particular relevance to them and they were unlikely to know the actual value. The "subtle genius" in asking them what they would sell it for, was that it imputed a sense of ownership.

A second group of similarly situated college students was shown the same ash-tray and asked what they would pay to buy it.

The first group's average price to sell was $8. The second groups average price to buy was $5.

The study has been performed many times and the result is always they same.... people that own something place a higher value on it than people that don't own it.

This holds true regardless how they acquired the object ... purchase, inheritance, gift, found it, etc..

The psychologists can tell you why (I have my ideas, but I'll leave that to them). For ease of explanation, I've coined the phrase "psychological aberration" to describe this phenomena.

Let me add some anecdotal evidence.....

1) I've been fishing with a group of "buddies" for over 50 years. They are all seasoned, experienced fisherman. They can judge the size/weight of a landed fish with uncanny accuracy, yet they consistently overestimate the size/weight of a fish they have landed.

2) People selling a house value the house much higher than the prospective buyer. They often have to reluctantly reduce it.

3) Watch "Pawn Stars" on TV. The people looking to sell almost always ask for way more than the buyer will pay. Many times, even after an expert has evaluated the item and stated its value, they continue to stand with unrealistic values. If the expert indicates the item is not authentic and worthless, many sellers still insist in holding to their price.

But, there is also a second part. After a person buys something, they have now become "owners" and will upgrade their assessment of its value. This happens, even without any new information. The reverse holds true with the seller, who now downgrades.

More anecdotal evidence.....

Most home-buyers will say, at the moment they agree to a price, that they paid a fair price, maybe a little more than they wanted. Ask them a month or two later and they will exclaim what a great deal they got. If they thought they had a great deal to begin with, well it is even magnified in its greatness. Meanwhile, the seller, at first reluctant to lower the price, now is happy they did.

Let's go back to "Pawn Stars". Before the negotiation even starts, the seller says they want $2000 and the least they will take is, say $1500. During negotiation the seller almost always backs down, taking less than even their "minimum". The post-negotiation interview always finds the seller happy and the "below minimum" price, fair.

Now, let's apply this to stock valuation. I love to follow the SA talk on Tesla (NASDAQ:TSLA) and Apple (NASDAQ:AAPL) because of the love/hate relationship of owners and non-owners. Be sure, I am not offering an opinion of either valuation, just trying to lend insight to the two sides.

Based upon the "ash-tray study", it is quite natural for the longs/shorts of any stock to differ on their valuations. In fact, this exists with every stock. It's just that the love/hate relationship exaggerates the results.

What is particularly interesting is that both sides, looking at the same data, will actually weigh the data differently to justify their position. What the psychological aberration tells us is that both sides have lost objectivity, simply as a result of their position.

Now, back to a stock such as TSLA. Let's give an example. An investor does all their analysis and homework and decides that TSLA, with upside potential to $190 is worth buying at $140. After buying, with no new information, the psychology of ownership will cause them to re-evaluate the upside to, say, $210. Nothing has changed other than, by going from a non-owner to an owner, they have changed their position and their bias ... TSLA's margins remain the same, TSLA's sales are not influenced, etc.. The investors action has changed nothing about TSLA. It is simply "ownership aberration".

The interesting counter-part, is that the "shorts", after going short, will overstate the potential downside and put a downside target below the amount that their initial analysis indicated.

This is not unique to TSLA, it exists with every stock. Just the way we're wired.

If one is aware of this phenomena, then they will be better able to objectively judge the value and potential of a stock by compensating for this psychological aberration.

So, how can knowledge of this tendency help us in our investing?

First, careful, thoughtful analysis is important. Understand that your actual position creates a bias in favor of that position. As soon as you change positions, the bias switches to the new position. Objectivity is degraded by the very act of taking a position (long, short or "on the sidelines"). Care needs to be taken to make sure this built-in aberration isn't unduly influencing our buys, sells and holds.

Second, when you buy a stock, use your analysis to set a target price and resist upgrading your assessment without new information. Once you have reached your target price, it's time to sell. Keep in mind that the "psychology" tells us that no matter what the price, you will think its worth more. It is this that is making you resist selling and causing you to "hang on". Discipline is the only anecdote.

Third, if you want to buy a stock on a dip, set a target and buy if achieved. Too many investors set an initial target, then when the stock reaches that target, downgrade, without any additional information. Remember, if you don't own it, the "psychology" will tell you its worth less. Trust your analysis and keep in mind that as a non-owner, your emotional reaction will always look for a lower price.

Look at AAPL. How many failed to sell at $700? How many of the people that said they would buy at $400 actually did? Not many, that's for sure. The answer is simple ... no matter how low it goes, the psychological aberration for the non-owner will create a negative bias. No matter how high it gets, the owner's aberration will influence them to think its worth more.

How about TSLA during its recent "gyrations". Many SA commenters said they would wait till it hit $100 before buying. I suggested, that if that is truly the case, consider selling out-of-the-money puts at $100 strike. You buy if it hits your "magic $100". If it never reaches $100, you make the premium. It is the logical extension of their buy-in target.

Now, anyone that did so, has made money. Those that didn't act on the strategy, were probably influenced by the psychology that no matter how low, it was not low enough. Text book psychological aberration.

So, if you want to profit, adjust your thinking and accept that you are not being as objective as you think you are. Your actual holding, or lack of holding, in and of itself, taints your objectivity in the direction of the actual holding.

I do have one last thought that is tangentially related to this topic. There are many more non-owners than owners of any particular stock. This means that there are many, many more people that think the stock is worth less than the owners think. This "psychology" is baked into the price. Which, as we will see, is good news for the owners.

There are both logical and mathematical arguments that illustrate the phenomena makes it more likely for stocks, in general, to go up than down. Simply put, there are more people underestimating value than there are people over-estimating value. We know that stocks can be fundamentally under-valued, but this means that stocks are psychologically undervalued. Of course, psychological undervaluation is of little help if the stock is fundamentally over-valued.

Now, that doesn't mean that TSLA, AAPL or the S&P itself will go up or down, today, tomorrow or the next year. There will always be bull and bear markets, winners and losers, and most importantly, overvalued and undervalued stocks. It just suggests that "up" is more likely than "down".

Conclusion: The stock market is driven by fundamentals, technicals and also psychology. The fundamentals and technicals apply to "something out there" and there's not much we can do about them.

This psychological aberration, on the other hand, applies to our perception of value. This is great news, because, once understood, it gives us something we can control.

What it indicates is that the logical thought processes that we use when picking a stock or an investment approach will be distorted, in our minds, by the simple process of implementing them. The best way to overcome this distortion is to consistently apply these same analytics at all times and update your assessment when additional information is available, not on some "feeling". I guess, it's what we call discipline.

This aberration also helps to explain why disciplined professionals sell before the retail investor. That's why, when the market falls, retail generally gets the short end of the stick. It also explains why disciplined professionals are more likely to go back in at low points while the retail investor stays out and doesn't enter as timely.

In the end, this means we need to take extra care and be disciplined in our approach. Otherwise we are more likely to succumb to some evolutionary aberration that distorts reality.

Source: Psychology, Valuations And The Stock Market

Additional disclosure: I buy and sell AAPL options and options on the S&P