I keep seeing the same YouTube ad marketing a class on how to make a fortune in the stock market. The pitch goes something like this: “If you’d put $100 into this stock, you would have made millions!” Is it that easy? After all, the numbers don’t lie. If only we’d bought Tesla, Amazon, or Apple when they debuted, we’d all indeed be very wealthy.
The case FOR hot stocks
When people buy hot stocks like these, they want to make money. To them, there are two big reasons why buying these companies make sense:
1. Their past returns are astronomical.
Looking at past returns can give anyone a case of FOMO. Yes, long-term returns have been over 1,000%, but even short-term performance has been crazy good.
2. They are “good” companies to own.
Besides extraordinary performance, these companies seem like solid buys. Amazon isn’t going away any time soon, right?
The case AGAINST individual stocks
I don’t think long-term investors should devote any significant amounts of their net worth to buying individual stocks. Why?
1. Falling victim to recency bias.
Recency bias means we put more weight into recent events rather than historical ones. If a stock goes up, we think it will continue to increase in value. If the market falls, we’re convinced this trend will persist.
The recent performance of a stock has no bearing on its future price. With any hot stock, we can fall victim to recency bias by convincing ourselves the current trend is bound to continue.
2. You probably would have bailed on Amazon.
The problem with thinking, “If only I’d have bought Amazon…” is you’re assuming you would have had the foresight to stick with it.
The path Amazon took to be the third largest US company by market capitalization wasn’t easy. Consider these stats:
- 107 times, Amazon’s stock fell 15% in a matter of three days.
- It lost 6% in a single day 199 times.
- It fell 95% during the Tech Bubble.
The volatility of individual stocks can be off the charts compared to a diversified mutual fund or ETF; something most investors aren’t prepared for.
3. The market may have priced in your predictions.
This one is harder to understand. Yes, I agree these companies are “good” companies that make a great product or provide an exceptional service. But future success may have already been considered when pricing the stock.
Think of it like this: millions of investors are buying and selling stocks daily. The current price of a stock represents the best guess at that company’s value, taking future expected earnings and successes into consideration. We don’t know what future products or breakthroughs have already been expected by investors!
Even if a company continues on its path of success, this doesn’t mean the stock price will continue to soar. Chances are, the future price appreciation will slow compared to its historical numbers.
4. The largest stocks tend to underperform going forward.
The market has become concentrated with five companies (Facebook, Apple, Amazon, Microsoft and Google) accounting for over 20% of the S&P 500.
To be one of the largest companies, your stock needs to perform extraordinarily well. But what does this mean for future performance? Research shows after landing on the list of the ten largest US stocks, these companies underperform the larger market on average over the next five and ten years.
5. It’s hard to formulate an exit plan.
Let’s say you buy some individual stocks. How long do you hold them? What will you do if the price gets cut in half?
When you buy “the market” (via a mutual fund or ETF), you don’t need an exit plan. This is because you are buying a broad basket of US companies. Our belief is these companies will keep growing. Failing companies will fall out and new companies will join in.
However, it’s much trickier when you invest in individual enterprises. History tells us that companies will fall out of favor and even go bankrupt. When this happens is anyone’s guess, but we know new establishments will eventually take over the leadership currently occupied by today’s winners.
This isn’t a jab against any one of these companies. I don’t hate Tesla. I use Amazon a lot, and I agree they will be with us for a long time. There’s no such thing as “easy money” in the stock market. Investing in individual stocks is difficult and something I don’t recommend for most people.
Interested in how you should be investing? Reach out today, we’d love to set up a time and chat together about your financial future.
