The Tootsie Roll is an iconic American candy. Who among us hasn’t experienced one of the sweet little nuggets? As a kid, they were delicious. I remember eating piles of them on Halloween or out of a piñata at a birthday party.
Today, I find them mildly revolting. But people still buy them. Why?
Consider the following 4 chocolates:
Which chocolate do you prefer? I would guess the majority would pick See’s, followed by Ghirardelli, then the Hershey’s Kiss, with a few die-hard Tootsie Roll lovers holding strong.
The reality is, See’s makes a higher quality product that most of us prefer to a Tootsie Roll or Hershey’s Kiss. But did you know their revenues are actually one-fifth the revenues of Hershey’s? Hershey’s makes an inferior product but sells 5 times as much.
How can this be? Try this question again.
Now which chocolate do you prefer?
See’s chocolates cost 6 times what the Hershey’s Kiss costs, and more than 10 times what Tootsie Rolls cost. As consumers, we respond to those prices by adjusting our purchases. At those prices, now a Hershey’s Kiss doesn’t look so bad. Most of us leave the See’s for special occasions.
In other words, we don’t consider only quality, we consider value – quality for the price.
Okay, so many of you are probably thinking, thanks Captain Obvious. This is so simple. We all know that prices affect our spending habits.
But, as obvious as this concept may seem when considering chocolate purchases, I have seen time and again investors completely ignore this concept when choosing investments.
Tell me if any of these thoughts sound familiar:
“Company ABC makes really cool gadgets. Everyone I know has one. Maybe I should invest in some of their stock.”
“I just saw on the news that Company XYZ doubled their profits last year. I better buy some of their stock so I can cash in on that growth.”
“Emerging market economies are really struggling. I better sell my emerging markets fund so I don’t go down with the ship.”
All of these thoughts probably actually sound like logical arguments. But do you see the disconnect? In each of these thoughts, there is no consideration of price that we instinctively use in our chocolate purchase decision. True, Company ABC might make really popular gadgets, but how much do you have to pay to invest in ABC stock?
So, what does the Tootsie Roll teach us about investing?
Smart investing is not an exercise in finding good companies. Just like a good chocolate, good companies come with higher price tags. Intense competition drives stock prices to fair value – good companies are expensive and struggling companies are cheap.
So how should you determine which stocks to invest in? Again, we can look to the Tootsie Roll.
You would never give Tootsie Rolls as an anniversary gift to your spouse, but you might buy a couple pounds for a 5-year-old’s birthday party. Just like your choice in chocolate may vary based on your tastes and situation, so too your investment portfolio should be unique to you and your individual needs, goals and preferences.
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