Tuesday, January 15, 2013

What is the price of worthless information?

Consider the following hypothetical:
You meet a benevolent stranger on the street. Just assume that you have every reason to believe and trust him that the following offer is on the level. He has both $100,000 cash and $100,000 worth of an S&P 500 stock at current market value. His offer is to give you either the cash or the stock, but you have to pay him to learn what company the stock is for. It is the middle of regular business day; so the market price of the stock is changing as you decide, but once you decide, you get $100,000 worth at that moment (assume fractional shares are available).
How much do you pay?

The answer below the fold.

Hint: This might just be a story about Billy Joe and Bobbie Sue.

As a wealth management professional, I come across many situations where people for one reason or another find themselves holding a large amount of individual common stock. Inheritance, company profit sharing and options, and charitable bequeaths in the case of non-profits are some of the more common reasons. In most cases the prudent and logical decision is to liquidate the stock for reinvestment in a more diversified portfolio. But almost always the client has hesitations about simply selling the stock. The behavioral finance literature cover many of the reasons why this is the case--the illusion of control and the endowment effect along with overconfidence, familiarity, and loyalty biases can all be at play.

Getting a gift or potential gift of stock does not make one a stock market analyst. Couple this with the most likely case that markets are very efficient, especially the US large-cap stock market, and you now have all you need to confidently reject the stock at any price. The current market price is the best guess anyone could have as to the value of the stock. To pretend to know more is throwing good money after worthless information.