The Rational Investor… or Not?

This is the last post in a series of six blog entries focused on topics that might be of interest to the Millennial generation. If you would like to see our attempt at making these subject matters entertaining, visit our YouTube page to see a video version of this article.

 

So here’s the setup: you have two large pizzas. One is cut into four pieces, the other is cut into eight pieces. Would you rather have one piece from the former, or two pieces from the latter? If you asked a hungry four-year-old that question, he’d probably be totally confused because you used the words “former” and “latter.” But then he’d go for the 2 pieces because in his mind, two pieces are more than one. Of course, anyone with a basic knowledge of fractions knows this is a trick question, because it’s the same amount.

Let’s imagine now that the pizzas are companies, and the pieces are shares of stock in those companies. You have $1000 to invest. Company A’s stock price is $50, and company B’s stock price is $100. Assuming that there are no trading costs, you can purchase 20 shares of company A and 10 shares of company B. All else equal, which would you buy? Answer: it doesn’t matter – your investment in either company is the same. You’d be surprised at how many people would choose company A because you get “more” shares of stock or because they think the shares are a better “value” by virtue of having a lower price per share. The thing you have to realize is this – a company can issue any number of shares it wants to. If the price per share is $100 they can issue a 2-for-1 split, and now you’ll have 2 shares worth $50 each for every one you had before. Your total dollar investment in the company doesn’t change, though.

We all want to believe we are rational and that emotions are only something that affect other people, but it just isn’t true. We all have made mistakes like the investor in the example above and that’s why behavioral finance is one of the fastest-growing branches of psychology. This is just one example of common investor misconceptions but there are many more – click on the link above for a lighthearted look at a few that we see from time to time. Remember to always discuss your investment decisions with your advisor, so that he or she can lead you in the direction of the logical and unbiased choice.

Sarah DerGarabedian, CFA
Portfolio Manager

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