It’s one thing to pay more for a stock when a company has delivered added value, or to sell when it has lost value. It’s quite another to buy just because the price is rising, or sell because the price is falling. In the first case, if we respond in proportion to the change in value, it can be a sound decision. In the second case, if we react to changes in price rather than value, we can end up chasing momentum and losing big.
Price and value are not the same thing.
In emotion-driven markets prone to wild momentum swings such as the resource sector, forgetting the difference between price and value can cost us dearly.
You probably know this well. The fear of missing out (FOMO) is a classic example of momentum-chasing that so often ends badly. It’s pretty basic financial sense.
The problem is that there’s a lot of noise out there that can confuse the issue. And when price rises above value for a long time, it can be very hard to resist FOMO.
Resource companies seem to be particularly skilled at putting out press releases that seem to add value, but don’t really. Sometimes they add potential for future value, as when more land is acquired, or a new database, or a new tool. Sometimes what’s presented as a value is really just a cost, such as huge tracts of land that will never be explored or expensive gadgets that rarely get used. (Click here for more on press releases that seem to add value, but are really just noise.)
Back to the root of the problem I’m trying to highlight, here’s how I see it:
- Investors look for performance. Fair enough. Past performance doesn’t guarantee future results, but it’s good to know if someone has ever been able to do what they claim. That’s why I publish a track record of all my closed trades.
- Investors tend to buy into funds, indices, ETFs, or even humble newsletters when performance is positive. This “betting on winners” may look like pursuing value, but unless there’s due diligence on the fundamentals that supports a thesis projecting continued positive performance, it’s actually chasing momentum.
- Investors tend to buy sell funds, indices, ETFs, or cancel their newsletter subscriptions when performance is negative. This can be a rational response to value, if it’s based on a careful examination of the fundamentals, but it’s often a knee-jerk reaction to pain. That’s again falling prey to the momentum beast.
- Because of this tendency to buy when performance is positive and sell when it’s negative, many investors reverse the speculator’s formula. Investors often end up buying high and selling low—even when the fund, index, ETF, or humble newsletter goes on to deliver positive performance when all is said and done.
- How can intelligent and experienced investors fall into such an obvious error? Because they think they’re buying value, but they’re chasing momentum. Since they aren’t the fund manager, ETF asset allocator, or humble newsletter writer, they usually don’t have all the information needed to make a fully informed judgment of the value proposition. It’s easy for investors to trust professionals to judge for them when performance is positive, and hard when it’s negative—hence the tendency to buy high and sell low.
In short, clients often lose money even when they invest with winners because they don’t have the conviction of the trade that the person doing the research and calling the shots has.
The good news is that this psychology exacerbates momentum so often and so much, it can turn what would be a modest win in a more rational market into a spectacular win in the real world. Even the downside of this can be good, as it can create terrific bargains in assets that are objectively deeply undervalued.
This is why I say momentum is great—but no reason to buy or sell.
- If the value in an asset hasn’t changed but the price has gone way up, that doesn’t make me want to buy more. It makes me think of taking profits or exiting entirely. At the very least, I’d put an Upside Maximizer stop-loss on it.
- If the value in an asset hasn’t changed but the price has gone way down, that doesn’t make me want to sell. It makes me want to buy more. Maybe a lot more.
When I do head for the exit on a losing position, it’s because the speculation has actually failed. That can be due to management failures, Mother Nature simply not cooperating, a change in the markets, or some other factor. (See this article for more on exit strategies.) But it’s never been just because the price is down.
That’s my take,
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