Thursday, 3 May 2012

Availability, the Price Pressure Hypothesis and Facebook's IPO.

Do more words start with a K or have a K as the third letter?

The majority of people will answer the former. However, words with a K as third letter are two times more likely to occur in a typical text than those starting with a K. This post will attempt to explain how by understanding this basic heuristic we can better understand our own investing decisions and draw conculsion to what this means for facebook's impending IPO.

The reason we get this question wrong is due to the availability heuristic,  a mechanism humans have embedded in our brains which makes us believe that the ease that things come to our minds is equatable with the probability of that thing occurring. So as it is far easier to think of words beginning with K (King, Kangaroo etc)than those with K as a third letter, our mind tells us, there must be more of those words around.  But we are wrong.....

So, how does this help us?

Retail investors have a massive variety of stocks which they can buy. However, they only have a very small number they can sell (those they own).  The price pressure hypothesis states that due to this dynamic higher level of investor attention to specific stocks results in positive short term price pressure and long run underperformance. This research has been extended to IPOs showing the same findings.

This then is clear evidence of the availability heuristic occurring in markets. Stocks with a peak of interest (measured by google searches in the above referenced paper) go up briefly then underperform in the long run, this trend holds for IPO's. (Obviously this is not the case for all of them, but they are more likely to follow this pattern than not).

Which is all well and good but what can we practically take from these findings?

If we apply the findings to Facebook's much hyped IPO it is clear that this stock is clearly highly available in investors minds. Probably all the more so for those of us who use it on a daily basis. Which should send alarm bells ringing. So people are constantly mentioning facebook making it avaialble, investors cannot sell it therefore they can only buy.
So i would expect to see a flood of retail investors in its early stages, pushing up the price for a short period away from it's equilibrium and leading to long-run underperformance. The next question is for how long will the stock underperform?

Here, i’m a little reluctant to give exact dates (then i could easily be proved wrong and we wouldn’t want that would we). However, If we look at apple we can draw some comparisons which may help.

Apple stock owners are far more likely to own apple products, facebook stock owners will
 more likely to be facebook users. Common sense, right?  However, this means that the investors are likely to have assumed that as they like the product so the market fundamentals must also be good. (Based on the Halo Effect which I will write about in the future.)  This means that as long as the product is highly rated the stock is always destined to overperform, with the big players wary of shorting it due to the long-term over-pricing of the stock.

 In terms of investment strategy the conclusions we can make for ourselves are try to make investments decisions by sticking to sounds maxims to bring long term returns, rather than based on growth projections or your thoughts about a particular product.  Do not let your weak and fallible mind convince you into something where the numbers aren't right.

So conclusions for those looking for long term value: stay away from facebook, sell any apple shares you own.

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