Two of investing’s most important principles are “understand that markets are efficient” and “diversify.” I learned both principles the hard way when, as a naïve high schooler who thought himself very financially sophisticated, I got a couple of hot stock tips about companies with innovative products that were going to change their industries and make their shareholders rich. Wanting to be one of those rich shareholders, I decided to buy.
I quickly lost everything I put in. It was about a $1,500 mistake, ultimately, which was a not-insignificant sum for a teenager in the mid-90s. I should have put the money in an S&P 500 index fund, but no, I had to fly close to the sun–and I got burned.
Since then, I’ve learned to respect the efficient markets hypothesis, which says that asset prices reflect all publicly available information. Markets might not be perfectly efficient, but they’re efficient enough that most investors should recognize that if they know something about a stock, the price already reflects it.
Here’s an illustration from another financial world that was near and dear to my heart in those days: baseball cards. In 1987, Mark McGwire of the Oakland Athletics became my favorite baseball player. I thought he had a cool name, and his 49 home runs that season broke the MLB rookie home run record. The record would stand for thirty years before Aaron Judge of the New York Yankees would hit 52 home runs. That record, in turn, would be broken two years later by Pete Alonso of the New York Mets, who hit 53 home runs in 2019. I collected McGwire baseball cards and “invested” a lot in them in 1997 as I figured that his return to super-slugger form after a few injury-plagued years meant they were a pretty good investment. To my pleasant surprise, he was traded to the St. Louis Cardinals–my favorite team–near the end of the 1997 season. He finished the 1997 season with 58 home runs.
He got off to a torrid start in 1998, and the story of the season was his race against the Chicago Cubs’ Sammy Sosa to break Roger Maris’s record of 61 home runs in a single season. He finished the year with a remarkable 70 home runs, including a home run in his last at bat. He followed it up with 65 home runs in 1999. It was a performance for the ages, and I remember seeing his 1985 Topps rookie card listed at $200.
Had I known what was coming, I would like to think I would have sold out and put it all in a mutual fund. McGwire retired in 2001 following two injury-shortened seasons. A few years later, rumors about steroid use in Major League Baseball landed McGwire in front of a congressional hearing. In 2010, he finally admitted he had used steroids. The value of my collection cratered. Professionally graded cards in perfect condition still command high prices on eBay, but a quick internet scan shows that you could get a McGwire rookie card comparable to the one I had for under $30.
When stock prices dip suddenly, some investors think it’s a good time to buy because the price will inevitably go back up. This is a mistake, just like it would be a mistake for me to go on eBay and buy up McGwire rookie cards at $20 and $30 each on the conviction that they would soon get back to the lofty prices they commanded in the late 1990s. However, the price tags you see for McGwire cards reflect the publicly available information that his achievements were tainted by steroid use. History cannot be undone, and the unsavory legacy of MLB’s steroid era will forever be reflected in McGwire (and Barry Bonds, and many others’) card prices.
Had I understood what the efficient markets hypothesis implies, I might have invested more wisely–perhaps by putting more of my money into index funds and less of my money into individual stocks and collectibles. Baseball cards and other bits of sports memorabilia were great fun, of course, but they weren’t a very good investment.
My teenage investing self also didn’t know the importance of diversification. In response to hot stock tips, I put my money into just two stocks and, therefore, exposed myself to a lot of risk. When things went sour for them, I lost it all. Had I put the money in an index fund, then I would not have faced nearly as much risk. I would also have a lot more than nothing to show for it.
I have, of course, grown wiser as I have learned more and grown older. I hope my students and my children don’t repeat my mistakes, and it warms my heart when a student or alum tells me they’ve opened a Roth IRA or when I can advise a high schooler who has been saving up so he can buy a share of Amazon stock to put the money in a mutual fund instead. Managing your money wisely isn’t especially glamorous, but it certainly beats risking it all and ending up with nothing.
The post Why Acting on 'Hot Stock Tips' Is a Good Way to Lose Money Fast was first published by the Foundation for Economic Education, and is republished here with permission. Please support their efforts.