Scenario: I bought a stock for Rs 50. My intrinsic value estimate was Rs 100. The stock quickly doubled and then some more. It quotes at Rs 125 now. What should I do?
The most common response I read and have also heard from friends is this – Sell half your holding and recover your investment. What you leave behind is your profit. Let it be in the market as can afford to play around with it.
I have myself engaged in the above logic. However I find this logic completely faulty. My ‘investment’ now is not Rs 50. It is Rs 125. That is the money I have now with me. I can sell the stock completely and choose to invest the money in another security or maybe just buy a Flat screen TV or whatever I fancy :)
The above is a case of anchoring bias. We tend to anchor our thinking to the purchase price of the stock. The purchase price is history. The current price is what matters
Lets take another case
I buy a stock for Rs 50. My intrinsic value estimate is Rs 100. The stock drops to 40. I investigate and realise that I have made an error and the intrinsic value is actually 35 only. What should I do?
The price of 50 now has no meaning. The stock has dropped and is still quoting above the intrinsic value. A rational response would be to take a loss and move on. Before I sound any more preachy, let me tell you I have been guilty of the same thought process. I bought SSI at Rs 1900 and rode it right to Rs 100.
Personally, I think the most rational approach is to constantly evaluate the stock price with your conservative estimate of intrinsic value. If the stock sells for more than intrinsic value , sell or else hold. Nothing else matters! not the price paid for the stock or the current level of the market.