April 08, 2019
By now, everyone has heard that stock picking is a fruitless pursuit. These days you have index funds and ETFs tracking whatever your heart desires. It is generally accepted that passive investing is the way to go — at least in my social circles.
And then you have Lyft going IPO and everyone loses their collective minds.
I saw friends buying at IPO; speculating openly on future short term price fluctuations; using leverage and all sorts of other shenanigans.
What happened? Did we forget the basic economics we all preach? Or has the glittering radiance of speculation blinded us?
Allow me to offer this story as a demonstration of my general observations.
About a week ago, I was in-line to an Indian burger restaurant (yum) with my friend Igor waiting for our order when he revealed to me that he bought some stock in Lyft.
“Why would you do this?”, I asked, looking confused. “I thought you were doing the whole passive investing thing”
“They are going to be huge”, he replied.
“Okay… but isn’t it risky? putting all your eggs in one basket and all that.”
“Nah, I only invested $2000.”
Let’s pause here for a minute.
I wish I had a $5 Lyft credit each time I heard some form of this argument. Here’s what Igor is saying:
So which is it? Clearly, Igor has no clue which way it’s going to go (just like the rest of us). That’s why he’s hedging his bets and risking a mere $2000. This is of course the exact argument used to justify index investing; you don’t know what’s going to happen so you hedge your bets and count on the upward tendency of the overall market.
I pointed this out to Igor but he doubled down.
“True, but the index will return you what? 7–8% a year. Lyft can grow way faster than that”
“Okay”, I said. “Do you think Lyft could ever be bigger than say…Tesla?”
I have no opinions about the relationship between Lyft and Tesla. As of our conversation, Tesla was roughly twice as big as Lyft. That means Igor was saying that Lyft can at best double in size.
His cut of all that growth? another $2000. He doubled his money. And this is assuming the most generous outcome.
What about the downside?
The gain and loss on the stock is a wash since we don’t know the direction it’s going to go. The time wasted following the IPO, doing your research and picking the right moment to buy is likely negligible. So what’s my problem?
First, let’s stop pretending Igor is investing. He isn’t. This is a gamble. No better than putting your money on red at the roulette table.
Second, and more importantly, this usually manifests in a slightly different portfolio. I’ve seen too many people to count who believe in indexing but set aside a fraction of their portfolio for these activities — usually about 10%. If someone’s portfolio is $100k, $10k is set aside for personal stock picks — shots in the dark if you will. They even have a cute name for it. They call it “fun money”.
Putting more money into a single company doesn’t make the problems go away — it makes them worse. Wild swings in a single company could wipe out earnings in the rest of your portfolio for the entire year. To mitigate, people who adhere to the “fun money” portfolio allocation, spread their risk over multiple companies — usually about 10.
Say you allocated 10% of your portfolio to the “fun money” sector. If you spread the money evenly, and if my math is correct, you set aside 1% of your portfolio to each company.
What kind of performance do you expect from these “fun companies”? Say one of them grew 10 times. Your “fun money” sector is now 20% of your entire portfolio. This is phenomenal growth.
Your gain is an additional 10%. 10% is great, don’t get me wrong. But, if you are picking stocks and the stock grew 10 times, I would expect better performance.
Additionally, for a stock to grow 10 times, it must be a smaller company. There is nothing wrong with investing in smaller companies. However, for each small company that grows 10 times, there’s 9 that go bankrupt. Now you’re back to square one.
To mitigate the risk on the other 9 companies, you can buy more companies and spread your risk further. Maybe you could do 20, or 100 companies. That’s also problematic since you’re diluting your share in the well performing companies but wasting a lot more time managing your portfolio. Also, the more companies you pick, the closer you are to emulating the index anyway.
What’s the only logical conclusion? put all your money in the index and stop gambling. If you want fun, go play soccer.
Written by Leon Tager who lives and works in Seattle writing about a better life. You should follow him on Twitter