How investor sentiment can get you in trouble

(MoneyWatch) As just about everyone on the planet knows by now, newly minted Facebook shares had a first-day gain of just 23 cents last week, and lost nearly 11 percent on day two, Monday. What isn't so well known, however, is that other securities fell much more as investors' excitement over the IPO cooled.

First, some background: There's a strong body of evidence demonstrating that individuals tend to be influenced by investor sentiment. When investor sentiment is high, it leads to overvaluations of stocks in the high sentiment sectors. Examples of this are the "-tronics" era of the 1960s and the dotcom era that burst in 2000. 

Facebook's (FB) launch as a public company was perhaps the most anticipated IPO ever. Defying the expectations of many investors, after trading as high as $45 the stock closed the day at $38.23, an increase of just 0.6 percent. The result was that most investors who bought after the opening were sitting with a loss, some as large as 15 percent. However, there were others with losses. We'll focus on what happened to them.

There was a small group of publicly traded investment companies that owned pre-IPO shares of Facebook. Among them was Firsthand Technology Value Fund, Inc. (SVVC), which is really a private equity stock, similar to Fortress Investments (FIG).

Investment companies like SVVC touted ownership interest in FB as a way for retail investors get in on the action before the stock started trading publicly. And given that the supply of Facebook shares in the IPO was going to be limited, SVVC was an easy way to gain access to the stock indirectly. However, easy doesn't necessarily mean the investments were a good idea.

On March 31, SVVC reported net assets were approximately $24.56 per share. FB was its largest holding at 12 percent of assets. If SVVC were a publicly traded mutual fund company, $24.56 is the price you would have been able to buy and sell its shares. But, in fact, it was a lot more expensive. Fueled, most likely, by demand from investors wanting pre-IPO access to Facebook, Firsthand Technology hit a high of $46.50 on April 4, an 89 percent premium to the actual value of the securities it owned. It's even worse than that, because the $24.56 net asset value (NAV) consisted of $13.60 in cash, and the rest in public and private equity holdings. If we subtract the cash from the $46.50 high, investors were paying $32.90 for equities with an estimated worth about $11. That's a premium of almost 200 percent. The size of the premium is a perfect example of investor sentiment, not rationality, driving prices. On Monday, the fund closed at $18.69, a drop of 60 percent from its high roughly six weeks earlier.

A similar investment company is GSV Capital (GSVC). Facebook, Twitter and Zynga are among GSV Capital's 17 investments. Perhaps fueled by the financial media's attention to Facebook's IPO, the stock was trading earlier in the week as high as $19.20. Despite the fact that FB went off at the highest end of the estimated range and finished slightly higher, the GSVC closed Monday at $11.86  -- a drop of 38 percent in just four days.

These funds are not the only investments that can rise and fall far more than the actual value of their holdings. Some closed-end investment funds trade at prices that can be far different than their net asset value. The authors of the study "Investor Sentiment and the Closed-End Fund Puzzle" concluded that prices straying from their NAV were likely caused by "sentiment-driven investors," not rational, informed investors. The author of a similar study, "The Long-Run Performance of Initial Public Offerings," found evidence of long-run reversal of IPO stocks, which is likely to be a consequence of overoptimistic sentiment towards IPO firms.

The lesson is to not get caught up in the "new, new thing." There's simply no way to know if the new "social media" era will turn out better for investors than did the -tronics or dotcom eras. Therefore, the prudent strategy is to have and stick to a well-designed plan that meets your ability, willingness and need to take risk.

One last bit of important information. Not only have IPOs as a group failed to generate appropriate risk-adjusted returns, but the evidence presented in The Only Guide to Alternative Investments You'll Ever Need demonstrates that as an industry private equity has failed to deliver returns commensurate with the incremental risks -- the hope and the hype exceed the reality. Keep these facts in mind the next time you consider joining the herd.