What to do when share prices collapse

What to do when share prices collapse : Since hitting a high of $17.68 in February 2007, Aristocrat’s share price has fallen 87 per cent. Aristocrat is now one of two things: a good business with a cheap share price, in which case you should probably buy it, or a formerly good business with a price that more or less reflects a structural decline, in which case avoid it.

Despite the above-average risks, Intelligent Investor is currently of the former view. Time will prove whether we are right or wrong, but if you have your facts right, what might stop you from acting on them to your advantage?

Superficially, we live in a rational world. In real life, many of us act from emotion rather than rationality. We panic and sell when share prices fall and become overconfident when they rise. In short, we suffer from a whole range of psychological biases.

Social proof

Did your parents ever ask, '‘If your friend jumped off a cliff, would you jump off too?’'

That’s an example of social proof, also seen in the stockmarket when unfavourable news hits the headlines and prices start to fall. Many inexperienced investors get spooked and sell out, creating selling momentum.

The best defence against this is to analyse the facts, think independently and be prepared to go against the crowd. That’s how you beat the market.

Conditioning

Prolonged or painful share price falls also ‘condition’ us to expect bad news. Having framed our expectations this way, often unintentionally, it’s hard for us to change our minds.

This can lead to biased analysis, resulting in us overlooking wonderful opportunities to buy at a low price. The solution is to keep an open mind.

Recency bias

Recency bias, where we place more weight on the importance of recent events, is another common trap.

Humans are wired to expect the future to resemble the present. We struggle to predict change, which is why economist John Kenneth Galbraith once said, ‘'The only function of economic forecasting is to make astrology look respectable."

It’s easy now to imagine Aristocrat’s earnings collapsing permanently. With debt levels increasing, management is allowing competitors to feast on the carcass of what was one of Australia’s best businesses.

But very few were considering that possibility four years ago when gambling revenues were strong, the Aussie dollar wasn’t such a headwind and Macau, where Aristocrat has a dominant market share, was poised to eclipse Las Vegas.

Back then, most investors were contemplating what else might go well for the company, not what might go wrong.

Aristocrat’s destiny probably lies somewhere between these two extremes. The key point is to have a long-term view, weigh up the probabilities of a variety of outcomes and adjust your portfolio accordingly.

Patience

Patience is also critical for investors to benefit from turnaround situations. Adopting a long-term view is a necessity because turnarounds take years.

Those that plan to get back in when the outlook is clearer rarely do, or pay a much higher price for the reduced risk.

If you’re an Aristocrat shareholder you may want to consider which, if any, of these factors applied to you while you were watching the share price fall.

What if you’re thinking of buying in?

Anchoring

With the share price falling 87 per cent, it’s easy to assume Aristocrat must be cheap. But '‘anchoring'’ to past prices is like driving while looking through the rear view mirror.

Investors must keep up with the facts and weigh up the gap between the current share price and the stock’s intrinsic value. The larger the gap, the larger the margin of safety.

Confirmation bias

If you remember Aristocrat going through similar problems in 2003, it would also be easy to bet on another dramatic recovery. But this would reflect confirmation bias, where we only see what we expect to see.

Humans like to seek out patterns but, instead, investors should search for information that contradicts their investment thesis. As Prussian mathematician Carl Jacobi warned, ‘'invert, always invert’'.

Aristocrat’s competitive position is much weaker this time and there’s no guarantee the company will benefit from a cyclical upswing. This should be reflected in any portfolio weighting decision.

Commitment bias

For investors buying more as the share price falls, there’s a risk of commitment and consistency biases.

Studies have shown that horse racing punters become more confident of winning after they’ve laid their bets. Clearly, that’s irrational but the same response is triggered in investors when they purchase a stock.

The best form of defence against throwing good money after bad is to keep weighing up the facts as well as the attractiveness of competing investments.

Authority bias

That Aristocrat’s largest shareholders are value investors Lazard Asset Management and Maple-Brown Abbott might provide a sense of validation.

But following '‘the smart money'’ without doing your homework is an example of authority bias, where we place too much trust in authoritative figures such as doctors, lawyers, brokers and advisers.

At one point or another, most investors will become overconfident. US investor Seth Klarman says it’s a form of arrogance to say the market has it wrong.

But because you need to go against the crowd to outperform the market, it’s important to arm yourself with the facts. That also helps protect you from self-deception and denial.

Do-something syndrome

Stress can also trigger do-something syndrome. French philosopher Blaise Pascal said, '‘All of humanity’s problems stem from man’s inability to sit quietly in a room alone."

The human instinct to respond quickly is of great help in the jungle where it can mean the difference between life and death but not necessarily in the sharemarket. In many cases the right action is to do nothing.

Benjamin Graham offers this advice; "You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right and that’s the only thing that makes you right. And if your facts and reasoning are right, you don’t have to worry about anybody else."

The trouble is that, as outsiders, we can never know the full story. The future is uncertain and we must prepare for every scenario.

That means avoiding stress and emotional responses that trigger poor decisions. This is perhaps most easily addressed with appropriate portfolio limits.

Large portfolio positions should be reserved for well-run, stable companies boasting a long track record of profitability.

Keeping Aristocrat to less than 3 per cent of a well-diversified portfolio should help you sleep soundly in the knowledge that a poor outcome won’t kill your portfolio.