Sunday, 7 November 2010

Rational Thinking about Irrational Pricing

Depressed investors cause depressed stock market prices.

Selling pressure mounts and drives prices down.  Investors possessing even modest degrees of aversion to loss capitulate quickly, and the less fearsome succumb soon after.

A downward spiral ensues.

Value investors avoid these scenarios by forming a clear assessment of their averseness to loss.  

Only having assessed this characteristic honestly do they brave the choppy waters of stock picking.  

One way to grasp one's own loss aversion is to recognize that most people experience the pain of loss as a multiple compared to the joy of gain.  The average person greets losses with aversion on the order of about 2.5 times their reception of winnings.

The greater one's loss aversion, the greater value investing's appeal.  For the most acutely loss-averse investors, pure value investing is most suitable (Graham was extremely risk averse).

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