On the Right Side of Irrational

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You’ve initiated a long position in part because you believe other investors are undervaluing an asset. In short order, the situation flip-flops, and you now believe other investors are overvaluing the same asset. To what extent does your follow-up action depend on your time horizon?

Suppose you’ve initiated a long position partly because you believe an asset’s undervaluation will be corrected within an acceptable time frame, but not only does the value correct itself within that time frame, it over-corrects. In relatively short order, you’ve gone from being on one side of irrational — buying when the market price is too low — to being on the other side of irrational — holding when the market price is too high. (See “Which of These 3 Types of Investor are You?”.)

Initial feelings of vindication at having made an astute investment decision when initiating the position can quite quickly give way to worry about what to do with the now overvalued asset, and waiting too long to decide risks the unpleasantness of watching market irrationality dissipate again — this time taking with it what might have been quite exceptional gains.

Here’s an example. Back in April, I was considering two different additive manufacturing/3D printing companies — The ExOne Company (XONE) and 3D Systems (DDD). In my view, the former offered a more compelling case as an investment than the latter, and my choice of approach was reflected in my preference for unhedged long stock for the former and a short put for the latter (equivalent in terms of the profit graph to long stock with a covered call). Without going into the details, XONE won out in my comparison due to its opportunities in the industrial niche; relative to my time horizon, I believed that XONE was more undervalued by the market, and thus I was more confident in taking an unhedged position. (Had this not been the case, I would not have taken a position in the company at all, since options are not yet available on it.) For specificity, the DDD put at the November 32 strike was going for a little over $6 on 22 April, while XONE common stock was going for around $35 three months ago today, on 16 April. Courtesy of a screen grab from Yahoo! Finance, here’s a look at how the two have performed up until now, where XONE is in blue and DDD in red:

XONE vs DDD

As you can see, DDD has performed perfectly well, and the value of the short put has now dwindled to just 85 cents as the underlying has climbed to more than 50% above the strike. If this price should hold until expiry, the short put will have returned percentage gains (relative to margin requirements) comparable to the common stock, but with lower risk, due to the option’s initial premium. Alternatively, the nearly worthless put position can now be closed, sacrificing a small additional gain. The ExOne Company, however, has performed exceptionally well, having already doubled relative to its 16 April price before falling back somewhat. On the face of it, this is great news for both! But from my perspective, history is now repeating itself, and the XONE situation has changed significantly with regard to potential market irrationality: the current market price, in my view, now over-estimates rather than under-estimates the company’s value. So what’s next?

I’ve experienced this sequence of events — including, in many cases, the subsequent disappearance of such out-sized gains — enough times to want a clear answer as to what to about it. I don’t think I have one yet, but here are two particular questions an investor might ask when currently sitting on the ‘right side of irrational’ — holding stock acquired at a discount to their estimate of its value, a price point which is itself a discount to the current market value. (These questions presuppose that the investor is not interested in betting on the continuation of market irrationality but is rather only looking to prepare for its eventual dissipation. This would contrast with the case of a momentum trader, who may bet on exactly that continuation of irrationality, and whose primary exit strategy boils down to running for the exits at the first sign that irrationality is either dissipating or changing direction.)

  1. Over my preferred holding period, will the market’s estimate of value converge with my own, or even over-shoot to the downside?
  2. Over my preferred holding period, how will my own estimate of value compare to the market’s estimate right now?

Looking at the second question first, the idea here is to gauge how much of the investor’s anticipated future growth in value is already baked into the stock’s (inflated) price right now. Discounting future effects of mispricing by the market, how much room does it have to grow, and would that growth represent an acceptable return on investment? If it turns out the stock is, in effect, already fully valued with regard to the investor’s own assessment, then continuing to hold the stock without hedging the gains amounts to a bet on continuing irrationality.

The idea of the first question is to gauge the longevity of whatever factors are responsible for the market’s current mispricing; is the market’s estimate of value apt to ‘wise up’ or to carry on as it is now, and if it does ‘wise up’, will it over-correct in the other direction? This assessment naturally becomes more critical for shorter holding periods: if the investor intends to hold a given stock for twenty years, then a temporary bit of market euphoria or gloom about the company’s value is neither here nor there, but if the investor is already considering an exit in the relatively near future, then the impact of market swings which the investor believes to be overreactions may be very significant and potentially costly. After all, few investors find it any more palatable to take a significant hit against paper gains or even against the original investment just because they believe the market to be ‘wrong’.

Other things being equal, the transition from buying while a stock is undervalued by the market to holding while a stock is overvalued by the market represents a transition away from the market providing a ‘cushion’ against loss relative to the entry price and toward the market increasing the risk of loss, but relative to a position that includes unrealized (paper) gains. While selling a stock should never be a question merely of looking at what everyone else is doing — any more than buying a stock should ever be a question merely of looking at what everyone else is doing — in my view both the relative time horizon over which an investor expects the market’s assessment of value to converge with their own and the investor’s estimate of the stock’s future value compared to the market’s current value should play a central role in deciding what, if any, follow-up action is appropriate.

All material on this site is carefully reviewed, but its accuracy cannot be guaranteed; please do your own checking and verifying. This specific article was last reviewed or updated by Dr Greg Mulhauser on .

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