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Inevitably, the response was no, and the applicant would follow with: “I would probably buy the stock a little lower.” As an example, an analyst might identify General Electric as a favorite pick and set a buy price, or target-purchase price, at $27 when the stock was currently selling for $30. At that point I announced that I had an investment “time machine” that would allow us to peer into the future and see how stocks were doing. As I turned the dial on the machine eighteen months into the future, I observed that GE had risen to a price of $50 and asked if the analyst would buy the stock at that price. The vast majority would answer no, maybe at $42 or $45, but not $50. I turned the dial again and moved three years into the future. I observed that GE was selling for $80. The question again: Would you buy it here? And again, the answer was no, not at these high prices. As you can imagine, the longer the analyst participated in this charade, the less attractive the candidate was for the position. The point of the exercise was to reveal how little skill we have at telling the market what the right price for a stock should be. What amazed me was how long it took bright people to catch on to the game; sometimes I would get GE over $300 per share before the applicant realized what was going on. I hadn’t thought of this test until I recently perused a Wall Street analytical report prepared by an accomplished research analyst and support staff. The investment report made sense, although I noticed an eerie similarity to my analyst test question. This time, the “test” ran in reverse — the question might have been worded “would you sell” rather than “would you buy.” What was a little scary was that the example was real — not like one of my mental exercises. It was an actual case study of the fallacy of trying to set higher target prices to justify the purchase of a stock that was in the process of declining over 90 percent. The table below tracks changes in the actual stock price and the target price. At each step in this process there was little attention being paid to the decline in the stock price as a leading indicator of problems. Even when the stock rallied from its 9/29/01 low and exceeded its target price, the analyst responded by raising the target price, rather than recommending sale of the stock. New economic theories explain this phenomenon. In a recent book, Choices, Values and Frames, edited by Kahneman and Tversky, Colin F. Camerer describes an idea called the disposition effect: People like holding losers and selling gainers simply because people dislike taking losses and like taking gains. For analysts, it is easier to continue to justify holding a stock than to say, “I was wrong.” This example is an object lesson in the importance of overlaying selling disciplines on a stock price as a method of minimizing losses. This actual experience also points up the importance of admitting mistakes early rather than riding a stock down, justifying the holding on theoretical value, only to abandon hope after the stock has declined 90 percent. —
Tom
Nugent is Executive Vice President & Chief Investment Officer of PlanMember
Advisors, Inc., and an investment consultant for Wealth Management
Services of South Carolina. |
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number
of years ago when I periodically interviewed security analysts for employment,
I would subject their forecasting skills to a simple test — could
he or she make judgments as to the timeliness of a stock-price purchase.
I'd ask the applicant the name of his or her favorite stock. Then, using
that stock as an example, I would ask if this was a good time to buy the
stock. 
