Snapchat and the Substitution Heuristic

We have a cognitive quirk.

We have a bunch but let’s focus on one.

When faced with a hard or complex problem instead of answering it we swap it for an easier question to answer. We believe we have answered the hard question when in fact we answered a totally different question.

Substitution Heuristic

This is the Substitution Heuristic.

These are few examples from Daniel Kahneman’s book Thinking, Fast and Slow.

Target question: How much would you contribute to save an endangered species?

Heuristic Questions: How much emotion do I feel when I think of dying dolphins?

Target Question: This woman is running for the primary. How far will she go in politics?

Heuristic Question: Does this woman look like a political winner?

Snapchat

A more timely and real world example.

Is Snap Inc. (SNAP), aka Snapchat, a good investment?

A simple but complex question.

Snapchat recently IPO’d and like a lot of new publically traded companies it is not profitable yet. In lieu of earnings and cash flow, you need to figure out Snapchat’s path to profitability and how likely Snap is to achieve this goal.

Snapchat is a social network. You’ll need to track its daily and/or monthly active users. Is it growing or slowing? What is the demographics of its users? Is it popular with the young and tech-savvy or is this group moving on to something else?

Then there is competition. How does Snapchat fit in a world with Facebook, twitter, and other emerging companies?

Finally, you have to figure out an appropriate price to pay for Snapchat’s potential versus the risk.

I told you it’s a hard question.

The Easier Question

It is far far easier to swap these questions with do I use Snapchat? Do my friends use it? Do we like it?

That’s what a lot of millennials did when thinking about investing in Snapchat on the day of its IPO.

Trading activity on Robinhood, an online brokerage platform, jumped by half on Thursday as Snap began trading, with 43% of users active that day buying shares, according to the company.

Robinhood’s demographic already skews to the younger side, with a median user age of 29, the company said. But the median age among Snap buyers on Thursday was even younger, at 26. (That happens to be the same age as Snap co-founder–and newly minted billionaire–Evan Spiegel.)

Rebecca Shoenthal, a 22-year-old journalism student at the University of North Carolina at Chapel Hill, was among them. She said she bought four shares of Snap for about $24 each. She put in an order for them on Wednesday night, stipulating that she would pay as much as $40 per share.

Heuristics Help But Can Cause Trouble

Heuristics are not bad. They help us get through the day.

We face a lot of decision throughout the day and we don’t have time to contemplate everyone. Heuristics help us make quick decisions freeing up time for more important things.

Also, the answers heuristics give us are good enough but they can lead us into trouble. Especially with investing.

Snap Inc.’s Earnings

Snap Inc. reported its first earnings as a public company yesterday and it wasn’t good.

  • Slowing user growth
  • Stock compensation expense greater than annual revenues
  • Large increases in operating expenses

Snap was down over 20% after the announcement and the stock is now down 26% since its IPO.
SNAP Chart

SNAP data by YCharts

Heuristics, Investing, & Trouble

Because they didn’t answer the hard questions before buying Snapchat these young investors are unsure what to do now. And instead of asking the hard questions now, they are selling their shares.

On Robinhood, an online brokerage platform with a younger clientele, sellers of Snap shares outnumber buyers among users under 30. Ahead of the earnings report, the ratio of those Snap buyers to sellers was 0.80, meaning 80 hypothetical buyers of the stock for every 100 sellers. In the week after the IPO, there had been 280 buyers for every 100 sellers. For those over 30, Snap’s buy-to-sell ratio is currently 1.2 times, down from 3.1 times the week of the IPO.

Rebecca the UNC student who was excited about Snpachat’s IPO is starting to realize the questions that need to be answered.

Rebecca Shoenthal, who is due to graduate from the University of North Carolina at Chapel Hill this weekend, told the Journal in March that she bought Snap shares after their public debut because she was excited about the company.

In a follow-up e-mail Wednesday, she said that, “Facebook is certainly making things hard for Snap, especially since they have essentially the same product with a much larger user base already established.”[emphasis added]

Opportunity?

Does the sell off present a buying opportunity in Snapchat?

You’ll have to ask and answer the hard questions to determine that.