• Arne

How to avoid the most common behavioral bias in stock investing

Public opinion often indicates: buying stocks is a form of gambling and anti-social. This stereotyp will block you from becoming financially independent. You should learn how to avoid this bias and become a long-term investor instead.

Many people buy common stocks with the objective to resell them at a higher price. They lock at the changes in market prices of their holdings on a frequent basis. They believe the only benefit of holding stocks is the raise in market prices. This is not true!

When investing into stocks you should always remember that you purchase a company - and hopefully a good one. Of course, in most cases, as a private investor, you buy only a very small fraction of the entire business, but still you own it. Being a common stock owner gives you the right to vote your shares in corporate elections. Shareholder voting rights give you the power to elect directors at annual or special meetings. Eventually, the directors will select the CEO and other executives. Depending on the corporate law applicable to the business the terms might be a bit different, but the concept that you own the business as a shareholder is the same in most countries around the globe.

What a business does for you as a shareholder.

That being said, the major question is: what to expect from the business as a shareholder? Sure, the motivation for a holding shares in a particular business can be different, based on individual preferences. However, in most cases, you invest in a business with the objective to gain a financial profit. But how would the financial benefit find its way into your pocket if not through selling your shares? There are several ways how to participate from a successful business as a shareholder.

In my recent article on business valuation I have already stated the value of a business to be determined by its future cash flows discounted at an appropriate rate. I have also stressed that - as a business owner - your claim is what's left as the last piece of the cake after all obligations to other stakeholders such as employees, debt providers, suppliers etc. have been fulfilled. This very last piece is often called distributable profits since it is available to be distributed to all shareholders. Some even call it shareholders cashflow, but no matter the name the idea is that the shareholders eat last.

What should the shareholders do with the distributable profits? They have the following options:

  1. Distribute dividends,

  2. Repurchase own shares,

  3. Retain.

Which option to choose?

As always in business the answer is: it depends. In Startups and growth companies you will likely see that the owner retain almost any profit to the business to finance the growth and increase the long-term profitability of the business. On the other hand, in mature businesses you often see that company owners decide to pay out a dividend. The reason is that in mature companies you rarely find projects which increase the overall value of the business. Hence, as a business owner you prefer to pay out your profits to your pocket for consumption.

Repurchasing own shares is an alternative way often chosen by mature companies. While paying dividends means the company literally transfers the profits to the shareholders bank accounts, in a stock repurchase no such transfer is made. Instead, the company uses the profits to repurchase its own shares. By doing so, the amount of outstanding shares decreases and, hence, the value of the individual share. One major reason why shareholders vote in favor for repurchasing instead of paying dividends is the deferred tax benefit that comes along with it.