We Are Terrible at Imagining Why a Stock May Go Down

Most stocks underperform the index. Yet, none of you can imagine why something at 50x earnings might go down.

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Check out the links to our latest Power Hour live podcast! Now, some thoughts on protecting the downside.

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For me, there is nothing more exciting than finding a promising new investment.

After sifting through dozens of bad businesses with bad management teams operating in hyper-competitive industries, you finally identify a sensible company you think has a lot of upside. In other words, it gets the juices flowing.

This makes sense in relation to how the brain works. From what I’ve read on neurotransmitters such as dopamine, the anticipation of reward is more powerful than the reward itself. These chemicals function as an instinctual driving force that “inspire” us to action.

These instincts can blind us from seeing any potential downsides in an investment. I think it connects to Kahneman’s research on loss aversion:

In 1979, Daniel Kahneman and his associate Amos Tversky originally coined the term loss aversion in their paper criticising the expected utility theory and proposing prospect theory as an alternative descriptive model of decision making under risk.^[5] "The response to losses is stronger than the response to corresponding gains" is Kahneman's definition of loss aversion. "Losses loom larger than gains" implies that people by nature are aversive to losses and tend to avoid them. For example, given a choice between option A (50% chance of winning 1,000 Israeli pounds and 50% chance of winning nothing) and option B (winning 450 Israeli pounds for sure), the studied respondents were more likely to choose option B despite the higher expected value of option A (500 pounds). Loss aversion gets stronger as the stakes of a gamble or choice grow larger. Prospect theory and utility theory follow to make the person regret and feel anticipated disappointment for that said gamble.

We hate the thought of losing money so much that it can cause our subconscious to be unnecessarily blind to the potential a stock we own may go down. Which, sadly, increases the chances we buy a stock about to go down.

Let’s look at some of the replies to this tweet:

From a rough tally, we have people responding:

• Amazon x 5

• Crowdstrike

• Costco x 2

• Tesla

• Nvidia x 2

• Meta Platforms

• PayPal x 4

• Fiverr

• Hims & Hers

• Micron Technology

• Kroger

• Berkshire Hathaway x 2

• O'Reilly

• KKR

• British American Tobacco x 5

• Reddit

• Robinhood

• IAC

• Nike x 2

• Roku

• Baidu

• Molson Coors

• Sea Limited

• Disney

• Starbucks

• Visa

• Mastercard

• Accenture

• LVMH x 2

• PinDuoDuo

• Alibaba x 2

• Ulta Beauty

• Diageo

• Enphase Energy

• Sirius XM

• Axon

• Applied Materials

• Palantir x 2

• Microsoft

• JP Morgan Chase

• HelloFresh

• Markel

• Uber

• Lockheed Martin

Ummmm…are we okay everyone?

Four separate people said they would be “shocked” if PayPal was lower in five years. Really? Let’s take a look at the prior five-year returns for PayPal:

So a stock is currently down 50% over the past five years. But four responders said they would be shocked if it had negative returns over the next five years. Huh.

(For the record, I do not know if PayPal is a buy here. But I do know I would not be shocked to see the stock down five years from now.)

And that isn’t even the most ridiculous item on the list. Nvidia. Enphase Energy. Reddit. Robinhood (lol). You don’t think it is plausible that these stocks could be lower five years from now? You can’t imagine any scenarios where these share prices are in the gutter?

Investing is a game of probabilities. Understand that the future of a business is a set of infinite scenarios with varying probabilities of occurring. It is about weighing the risks along with the potential upside.

Understanding this doesn’t guarantee success. But ignoring the downside will lead put you on the road to failure.

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