Occasionally we’re asked about a certain stock or “investment idea.” The conversation often goes something like this: “My son (friend, neighbor, coworker, etc.) saw __________ on the internet and said I should look into it. What do you think?” Our first reaction to such inquiries is: “We’ve seen this movie before, and it doesn’t end well.”
There are always people trying to find (and too many trying to sell) the next hot investment. The buzz that these ideas create can result in the dreaded “fear of missing out,” aka FOMO. It’s no fun to watch your annoying brother-in-law strike it rich on ___________, while you’re invested in a sensible, low-cost, low-turnover, globally diversified, tax-efficient portfolio. Unfortunately, these investment fads often lead to temporary paper profits that don’t have any holding power. In the moment however, it’s hard to keep envy restrained.
An ironic and consistent thread throughout most of these fad investments is that those most willing to participate often pay no attention to the financials of the underlying investment.
Think back to the tech bubble we experienced in the late 1990s. Everyone was an investing genius just by purchasing anything internet-related regardless of the company’s earnings, cash flow, or market share. Most of us agreed that this internet thing was collectively going to turn into something big but taking risks on individual companies with no earnings was a fool’s game.
This “fool’s game” even has a name: The Greater Fool Theory. This theory states that fools are willing to buy something, regardless of valuation, assuming there will be someone (a greater fool) willing to come along and buy it from them at a higher price. Understanding this theory and the fact that eventually there are no more fools (and you could be the last!), can save smart investors from jumping into this stressful and costly trap.
“Can’t Lose” Stock Tips
In late March of 2020, we received an email from a client whose adult child was recommending two stocks and wanted our opinion: Zoom (ZM) and Teladoc (TDOC). Both had a great story and fit into the stay-at-home theme of the pandemic. Our response to the inquiry was the same as if someone had asked us about Pets.com in 1998:
- To really understand the financials of a company, it takes many, many hours of financial statement, market, and business model analysis. Not many individuals possess the skills or time to do this. An investor who buys a stock without doing this analysis is just a speculator.
- Individual stocks carry much more risk than most investors realize, and the investor is not compensated for this additional risk. Therefore, investors are much better buying the entire basket of stocks through an ETF or index mutual fund than just one, or two, or ten stocks.
- There is a very good chance that the individual investor would be purchasing the stock from an institutional trader who knows much more about the underlying company and is happy to sell at the current price.
- Stock prices already reflect all public information. If you know something material about a company that isn’t public and you trade on that information, this is considered insider trading and is illegal.
- A “good company” at a bad stock price isn’t a good deal. A “bad company” at the right price may be a much better deal. Most individuals have no idea how to tell the difference.
- The much better alternative is to purchase the entire stock market through appropriate funds. This is the sure way to make sure the investor owns the stock before it was “hot”.
It’s been over two years since we first looked at Zoom (ZM) and Teladoc (TDOC) and we were curious how the stocks had performed. Although both stocks increased in price in the early days of the pandemic, they haven’t fared so well longer term. Here are comparative results with the Vanguard Total Stock Market Index Fund (VTI) representing the total US stock market:
Prices as of March 31, 2020
- Teladoc (TDOC): $155.01
- Zoom (ZM): $146.12
- (VTI): $128.91
Prices as of May 31, 2022
- Teladoc (TDOC): $ 34.09 Price change: -78.96%
- Zoom (ZM): $107.45 Price change: -20.51%
- (VTI): $206.36 Price change: +68.42%
This is a great example of the risks of concentrated individual stock positions. Our client’s daughter would have made out much better with an exchange-traded fund (ETF) that tracked the broad stock market.
Beware of the Bubble
Investment fads and bubbles are nothing new. In 1841 the book Extraordinary Popular Delusions and the Madness of Crowds was published. It highlighted several instances in which investors were swept up by the “Fear of Missing Out” investment theme of the day. The stories were different, but the endings all shared a similar result. Investors who were caught up in the emotions of greed and missing out were dealt significant financial blows when the bubbles burst.
We wonder how many basements across America have large stashes of Beanie Babies that were purchased in the mid-1990s with the intention of selling at a huge profit to fund college expenses for their kids or grandkids. Since these toys didn’t do anything that would generate a profit, this was a perfect example of the Greater Fool’s Theory.
A good question to ask about an investment is “what does it do?” Most good investments should have a way of generating income aside from the future sale. Anything else falls into the camp of speculation. Yes, people make money speculating every day, but speculation is also the source of considerable financial misery.
This Time It’s Different—Or Is It?
Another common theme to fad investing is that it is frequently driven by the younger generation. They often think “things are different now and these old people are out of touch.” Unfortunately, the basic tenets of investing do not change.
“The four most dangerous words in investing are: ‘This time it’s different.’” Sir John Templeton
We’re currently in an era with many interesting and non-traditional investment options screaming for our dollars: Non-Fungible Tokens (NFTs), cryptocurrency, meme stocks, and Special Purpose Acquisition Companies (SPACs) to name a few. Sure, some people will make money on these, but many others will be hit with losses they can ill afford.
When investing for things that truly matter in life, namely education and retirement, there are no good short cuts. Risk and return have always been and always will be very closely related.