Small investors tend to hype the price of what I call 'Pop Stocks'
The other day, I was on e*Trade and they had a trading page with a list of the "Top five stocks of interest" - these were the stocks that the small traders on e*Trade were asking about or investing in. Interestingly enough, almost every stock was a computer or internet stock. Why is this?
People tend to buy what they know. And people trading online buy what is in front of them - their computer. So it is no surprise that Cisco systems, Apple, Dell, Microsoft, HP, and other computer-related stocks are traded often by the amateur investor. And similarly it is no surprised that the "dot com" stocks - Google, Groupon, LinkedIn, and the like - are busily traded by the amateur trader - as the desktop computer displays these brands all the time in sidebar ads.
And since the amateur investor has no clue what they are doing, they bid up the prices of these stocks into the stratosphere - with P/E ratios that are just, well, irrational.
What is going on here? Well, amateur investors have little data to work with. We don't know if a company is robust and poised to take over the market, or is internally rotted and ready to collapse. Our only data points are often the price history of the stock, which not surprisingly, is really the only data that online trading services provide you with.
So we look at a stock like ACME COMPUTERS and say, "Gee, the price has been going steadily up over the last few years, and I own an ACME computer and it's great! I think I'll buy the stock!"
But we have no idea whether ACME is about to be hit with an anti-trust lawsuit, or whether its iconic founder, Fred Works, is about to pass away rather suddenly. Perhaps the stock price will go up. Perhaps not. They are only as good as their next product. And historically, tech companies go from "hot" to "not" overnight - and back again.
The emergence of the small investor in the latter half of the 20th Century has caused great instability in the market. With low-cost brokerage houses, an average Joe can start trading online with only $1000 or so. With low-cost trading fees, such "investors" can buy and sell the same stocks over and over again, often in the same day. Their trading philosophies are often based more on numerical systems or mere familiarity with a brand name. These are the folks who are dumping stocks at the first hint of bad news and buying them back at the first hint of good news. They cause market volatility.
How can you avoid the Pop Stock phenomenon? Invest for the long term and diversify your investments. Buying a stock and hoping to make a killing usually means that you end up being killed. None of us are Wall Street Gurus, or we wouldn't be working day jobs.
Mutual funds may be a pig-in-a-poke, but at least they are professionally managed, and most mutual funds invest for the long haul and don't "churn" the client's money down to nothing - as traders often do. A well-diversified portfolio should include at least some mutual funds, I think, as your rate of return, on average, will be far greater than your own stock picks (statistically speaking and based on my own experience). And of course, you should be invested in things other than equities - including bonds, CDs, Real Estate, whatever. The more you can spread it around, the less you are dependent on one thing.
Stock picking, on the other hand, is really hard to do. Most of us pick based on brand names, or buy stocks that are "blue chips". If you are buying the latter, you might just as well buy a mutual fund, as there are funds that just buy those very stocks. Buying on brand name is more problematic. Some succeed, some fail, but often even if a product is popular, it may end up losing money for the company. Or even if the company does well, it may not do as well as its inflated stock price dictates.
Netflix is one such stock. I love Netflix, although it has changed in recent months and it seems to push more and more obscure movies on me, and it makes it hard to search online for films. However, they have a good business model and a good installed base of users. And from what I understand, they are making some money.
But the stock price took off last year in a manner that was totally irrational. In order for the stock price to make any sense at all, Netflix would have to have enormous profits or increase its user base by a factor of 10. And either option was not really viable. A good company? Yes. A good product? Yes. A good stock value? No. Too many Johnny Lunchbuckets had bid up the price too far.
Anything that is hyped is a bad deal, and this goes for stock prices (and odious talk show hosts who hawk gold as well). The best stocks to buy are often ones you've never heard of - and never will.