Whether you work in finance on Wall Street or run your own day care on Main Street, you’ve probably had an unsolicited conversation with a friend or colleague about a “can’t-miss” stock.
Sometimes, this conversation may be about some hot new product that kids are obsessing over. Sometimes it may include a great story about a new technology that will create a major long-term shift in a particular industry. Maybe the story will even include promises about a groundbreaking drug that will change the world forever.
On the surface, all of these stories make a lot of sense and seem like reasonable arguments for investing. Unfortunately, it usually takes more than surface-level ideas to make money in the stock market.
In a recent note to clients, Oaktree Capital’s Howard Marks described this type of investment reasoning as “first-level” thinking. According to Marks, first-level thinking is useless because everyone invested in the stock market can do it.
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By the time your friend or neighbor reads about a hot new cancer drug on a major media outlet, professional market analysts on Wall Street have likely known about it for months — or even years. They have likely assigned a probability to any possible risks associated with the drug’s launch, modeled the drug’s potential long-term earnings impact and bought or sold shares of the company’s stock accordingly. Maybe the drug hasn’t hit the shelves yet, but the potential impact of the drug has already been priced into the stock’s share price.
This past summer, Nintendo Co. had a huge hit with its Pokemon Go mobile game. In July, media reports came out that Pokemon Go had broken the Apple (ticker: AAPL) store download record around the same time that neighborhood parks were swarming with Pokemon hunters.
The idea that Nintendo stock was an obvious investment at the time is a perfect example of first-level thinking.
In the five months that followed those reports, Nintendo stock dropped 15.1 percent. Why? Second-level thinkers had invested in Nintendo stock weeks ahead of peak Pokemon Go popularity. The smartest of these investors recognized that the point at which the public was the most enthusiastic about the game was the perfect time to sell.
“What happens too often is that ‘crowded trades’ have already had their move. Therefore, as people get into the trade, it is at the tail end of the move or is about to do a bit of capitulation that often scares people the other way and causes a whipsaw effect,” says JJ Kinahan, managing director of client advocacy and market structure for TD Ameritrade.
For Nintendo, the Pokemon Go whipsaw happened when the stock plummeted from $38.25 to $24.65 (a 28 percent drop) within a matter of days back in July.
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When first-level thinkers think they have stumbled upon an “obvious” can’t-miss investment idea, they are often frustrated with the results. They can even become convinced that the stock market is unfair or rigged against them and share prices aren’t tied to reality. In truth, these investors are often simply late to the party.
Even after its whipsaw selloff in July, Nintendo stock was still up more than 31 percent from its June lows. Investors who got in before Pokemon Go grabbed all the headlines made a killing.
Owen Murray, director of investments at Horizon Advisors, says that the share prices of popular stocks can become temporarily detached from the company’s underlying fundamental performance.
“In many cases, by the time an investment idea becomes crowded, most of the profits have already been made by those who were early investors,” Murray says.
According to Nicholas Colas, chief market strategist for Convergex Group, some investors don’t understand that market expectations tend to have far more of an impact on a stock’s share price than company news does.
“Capital markets anticipate future events before they occur. In order for a crowded trade to actually make money, the news has to be even better than the crowd thought possible,” Colas says.
Those high market expectations are the primary reason why Nintendo stock plummeted more than 14 percent in the first four days following the December launch of mobile game Super Mario Run. The game shattered download records, but Nintendo stock tanked.
Frustrated Nintendo investors should remember that the market isn’t rigged. Expectations simply got out of touch with reality.
Crowded trades can work from time to time, but investors need to understand that the outcome of buying a popular stock is far from obvious. Colas says jumping on the bandwagon in the stock market is a lot like buying tickets to an over-hyped prize fight.
“You pay a lot of money to watch, and sometimes it is still a great event. But sometimes it ends very quickly, and you spent all that money for nothing,” he says.
To combat crowded stocks’ unpredictability, Kinahan recommends that investors accumulate a position methodically over time rather than going all-in on a popular stock all at once. “Being partially invested allows movement to be a friend and not an enemy. If the capitulation situation occurs, it can provide opportunity,” he says.
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Murray says investors considering a popular stock should forget about what has happened in the past and ask themselves whether the stock’s share price currently offers a compelling value and whether or not there are additional positive catalysts for the stock down the road. “If the answers to either of these questions are ‘no’ or even ‘maybe not,’ you might be better off looking for an investment opportunity somewhere else,” he says.
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Obvious Investments Are Often the Worst Possible Choices originally appeared on usnews.com
