Investing in High-Flyers

Question: Why not invest in some hot stocks like Netflix, Priceline.com, Tesla, solar stocks, etc.?  Wouldn't that be a way to make money quickly given how much they've recently gone up?

It's true that you might make money quickly in a "hot" stock.  You may even know someone else who has.  I remember a good friend of mine telling me in late 1999 how he had made $10,000 in a few weeks on an Israeli tech stock.  Of course, that period was followed by the NASDAQ Crash of 2000-2002, and I've never heard about a stock that my friend has bought again.

The following are some of the serious problems with such a speculative strategy:

1. These stocks are so risky you can't commit enough to a position to get a large payoff relative to your total assets.
2. Investors tend to overpay for "long shots" and underpay for near certainty, which makes it difficult to win consistently on long shots as described in the quote about gambling below.  So even if you did get a large payoff, it's almost impossible to repeat over time.
3. Buying these common stock "long-shots" is essentially gambling, which means that to win, you have to quit while you're ahead.  And gamblers never do that.
4. These types of risky stocks only do well for brief periods, usually toward the end of bull markets, so you're left without a long-term strategy.
5. Anyone who continues to gamble - and that includes nearly all "investors" in these types of stocks - eventually ends up with a loss.

The following quote from a sports column in The Guardian explains why gamblers are attracted to long-shots and why they are so unlikely to pay off.  This same logic applies to people who speculate in stocks like Netflix and Tesla:

“One, gamblers prefer a small chance of a big win to a big chance of a small win, so they overbet the outsiders. Two, bookmakers are comfortable with the prospect of paying many backers to short odds on a winning favourite but fear that a handful of lucky bets on a ‘rag’ might really damage their bankroll, so they offer cramped odds about the longshots and lay the market-leaders at close to their true price.

In other words, either punters are greedy or bookies are cowardly . . . actually, both could be true. Whatever the case, it’s clear that you’d have to be a very good judge to make a long-term profit by backing mostly outsiders.

So, all those people who get so vocal when they’ve finally hit a big-priced winner, should we dismiss them as mugs who will give up the game when they suffer the inevitable six-month losing run? How can such punters justify their reckless ways? Even if we accept that it’s more fun to back outsiders, that’s going to seem a tad hollow if it all ends in ruin.”