Consider this hypothetical example: The shares of a high-flying company falls 50%. You’ve heard of Mr. Market’s mood swings so you purchase the shares seeing the price dislocation as a terrific buying opportunity.
While you believe you're making a contrarian bet, you may have fallen victim to a behavioral bias: Anchoring (on a recent higher price like the 52-week high).
Value investors in challenged sectors like commodities, industrials and certain technology sectors, who are slow to re-calibrate their internal risk/reward models, may be more susceptible to this bias.
The Capital Structure
When a stock falls sharply, pay heed to the business’s capital structure – the debt and equity. The equity of a company, with tons of debt, could experience large swings for even small changes in the business’s enterprise value.
Say you purchase a home with a 20% down-payment. If the home price rises by 10% your equity in the home is up 50%. If the price falls 10%, your equity is down 50%. If the price falls 20%, your equity is wiped out. Equity investors sometimes forget this basic principle.
For more on behavioral biases in investing please refer to these prior posts:
- Mr. Market - Manic-depressive or Consummate Salesman?
- Don’t discount the grandma trade
- The Behavioral Aspects Of Investing And The Marshmallow Experiment
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