Making Sense of Hot Stock Tips and Investment Fads
Occasionally, someone asks us about a specific stock or investment idea. The conversation usually goes something like this: “My son/friend/neighbor/coworker saw something online and said I should look into it. What do you think?”
Our typical response is simple. We have seen this movie before, and it rarely ends well.
There will always be people trying to find the next hot investment and even more people trying to sell it. The excitement around these ideas can trigger the fear of missing out, often referred to as FOMO. It is not easy to watch a relative or acquaintance claim big gains while you stay invested in a sensible, low-cost, low-turnover, globally diversified, tax-efficient portfolio.
Many investment fads produce short-term paper gains without lasting value. In the moment, however, envy can override discipline.
A common thread runs through most of these fads. The investors most eager to participate often ignore the financial fundamentals of the underlying investment.
Lessons from the Tech Bubble
Consider the technology bubble of the late 1990s. Investors purchased nearly anything tied to the internet, regardless of earnings, cash flow, or market share. Many people correctly believed the internet would reshape the economy. Still, taking concentrated risks in unproven companies with no earnings proved costly.
This behavior even has a name. Investors call it the Greater Fool Theory.
The theory suggests buyers will purchase an asset at any price, assuming someone else will later buy it for more. Eventually, the supply of willing buyers dries up. At that point, the last buyer often suffers the consequences.
Understanding this dynamic can help investors avoid stressful and expensive mistakes.
“Can’t Lose” Stock Tips
In late March 2020, a client emailed us about two stock recommendations from an adult child: Zoom and Teladoc. Both companies fit the stay-at-home theme of the early pandemic and had compelling narratives.
Our response echoed general principles that were commonly discussed about Pets.com in 1998.
- To truly understand a company’s financials requires extensive analysis of financial statements, markets, and business models. Few individual investors have the time or expertise to do this work. Without it, stock selection becomes speculation.
- Individual stocks carry far more risk than many investors realize, and markets do not compensate investors for taking that added risk. Broad exposure through an ETF or index mutual fund generally offers a more efficient approach.
- Individual investors often buy shares from institutional traders who have deeper insight into the company and are happy to sell at current prices.
- Stock prices already reflect public information. Trading on nonpublic, material information is illegal.
- A good company can still be a poor investment if the price is too high. A weaker company at a reasonable price may offer better value. Most investors struggle to tell the difference.
- A more effective alternative is to own the entire stock market through diversified funds. This approach allows investors to participate before any individual stock becomes “hot.”
More than two years later, we revisited Zoom and Teladoc to see how they performed over time compared with a broadly diversified equity market.
Over this period, the individual stocks experienced significant volatility, while a broadly diversified equity market experienced a different return pattern.
This comparison highlights the potential risks of concentrated stock positions.
These examples are presented solely to illustrate general investment concepts. They are not intended to predict future results or demonstrate the performance of any investment strategy.
Beware of the Bubble
Investment fads and bubbles are not new. In 1841, the book Extraordinary Popular Delusions and the Madness of Crowds documented how collective enthusiasm repeatedly led investors into poor decisions. While the stories differed, the outcomes shared a familiar pattern.
Emotions such as greed and fear of missing out often pushed investors to suffer significant losses when bubbles collapsed.
You may still find basements filled with Beanie Babies purchased in the 1990s. Many buyers hoped these collectibles would grow in value and help fund future expenses. Because the toys produced no income or economic value, they relied entirely on finding a willing buyer at a higher price. The Greater Fool Theory applied again.
A useful question to ask about any investment is simple: What does it do? Most sound investments generate income beyond a future sale. Anything else falls into speculation.
While some people profit from speculation, it also causes considerable financial harm.
This Time It’s Different. Or Is It?
Younger investors often drive investment fads, convinced that previous rules no longer apply. But the core principles of investing do not change.
Sir John Templeton famously said, “The four most dangerous words in investing are: ‘This time it’s different.’”
Today’s market features many nontraditional investments competing for attention, including cryptocurrency, NFTs, meme stocks, and special purpose acquisition companies. Some investors will succeed. Many others will absorb losses they cannot afford.
When saving for education, retirement, or other long-term goals, shortcuts rarely lead to favorable outcomes. Risk and return remain closely linked, just as they always have been.
This is intended for informational purposes only. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from Savant. Please consult your investment professional regarding your unique situation.
Kenneth R. Duetsch
Managing Partner / Financial Advisor
CFP®, CFA®, MBA