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No Good Can Come of This

Ramit Sethi · January 20th, 2006

I bet my friend is going to be very unhappy soon. This is a story about her, but first let me tell you a story about my company’s board of directors.

We had an exciting deal and we were feeling good. But when we took it to our board members for their advice–they’re entrepreneurs with much more experience than we have–they were lukewarm on the idea. Actually, they told us we were being stupid: “If you don’t get this deal, you lose. And if you do get this deal, you still lose because the margins are so low. You lose either way!!”

When No Good Can Come of This, I am very wary.

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So, back to my friend. She IMd me yesterday and told me that her manager had a hot stock tip and should she get it? The stock had jumped over the past 3 months and he’d tripled his money.

With only that information, I told her that she would be stupid to buy the stock right away. First, is her manager really the best source of information? Second, if it’s jumped 3x in the last few months, isn’t it possible she’d be buying it high and later selling it low?

Also (god there are so many reasons this is a bad idea):

  • Was she going to do any research on the stock on her own?
  • Is 3 months really enough time to tell anything at all? Look, my arms look big today but that doesn’t mean I’ll be a muscleman in a month. Christ.
  • Did my friend understand what the company does, how its products are, and how the competitive landscape is? What about revenues, costs, etc?
  • And so on

She decided she’d probably invest anyway. Ok, her decision.

But here’s the clincher: Even though she has a great income, she is only putting in $500-$1000 for the stock so she can hedge her risks.

This strikes me as pretty weird: If she does really well, she’ll wish she had put more money in; in other words, she’s hedging herself out of any real success. And if the stock tanks, she loses all her money.

Either way, she loses! No Good Can Come of This.

Now, I see a lot of value in starting slow and not putting all your eggs in one basket. But if you’re not putting in more money because you haven’t done any research on a stock, that’s dumb. By doing a real, fundamental analysis, you can gain at least some certainty/information about the stock. And then, you can decide to either (1) invest a real amount (by her salary standards) or (2) not invest at all.

Yes, investing is a risk. But if your 2 potential outcomes are bad, that’s a bad investment.

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16 Comments

 
  1. Eric von Rothkirch

    People hate risk. They love to believe in ‘half-way.’ If she can only put a little money in, then it’s ‘safe.’

    But the best investments are never safe. They are leaps faith. As you suggest, you can always replace faith with knowledge. Take a leap of knowledge.

    And if you fail, you fail. People shy away from the All or Nothing mindset but there is no half-way. Most of the decisions we make in life are binary. One or zero. On or off. Yes or no.

    Life is all shades of gray, but decisions aren’t.

  2. this entry makes no sense. there are 2 scenarios:

    1) she has a good tip – she has a positive expectancy trade; good for her
    2) the tip isn’t good – the trade has no expentancy; given markets are already efficient, she should expect to come out even

  3. Running the idea through a diet of technical analysis would not hurt either, especially if she could care less about what the company sells or can’t trust what “analysts” are saying. Volume confirmed trends, its relative strength viz its sector or the futures, etc. are good places to start. Top 3 Indicators and more examples here

  4. Mike Willingham

    Ramit: I’d like to know the structure of your board:

    Criteria used to chose the members.

    Are the members compensated? If so, how? (monthly stipend, % of profits) Recommendations?

    What is the length of a members term?

    Thanks!

  5. Alex Givant

    I’ve been in situation when my co-worker put around $20,000 to stock of 360 network just because their building happens to be near our building. He bought is around $2 (down from 30-something) and said “How bad that could be, it has only one direction to go – up!”. After that 360 Network stopped payment for bonds, they dropped to $1, $.5 and way to few pennies. He lost all his money (he needed them badly to buy newer car). So, people to stupid things based on some strange decisions.

  6. Apparently, she’s confident enough to invest SOMEthing, but only as much as she’s willing to lose entirely. She should consider buying call options. The downside risk will be the same (in her mind) but the upside potential will be magnified.

  7. Chris Yeh

    While I agree that it’s better to be decisive than to be wishy-washy, there have been great investors who took the approach of “buy a little now, buy more later on.”

    For the big guys, sometimes buying a little bit of a stock is the only way to get themselves to pay attention. It’s like the way you pay more attention at a card game if you have money at stake.

    That being said, it sounds like you’re friend is being played by a classic combo of fear and greed–greed because she sees her boss making money; fear because she doesn’t want to miss out, but also doesn’t want to lose her money.

    In general, I think people should realize that picking individual stocks is hard work. Fund managers do it for a living, and they have a hard time beating the market. Why should I believe that I can do better?

    Focus instead on minimizing your expenses, saving as much as possible, and following a disciplined investment plan.

  8. Jonathan Radande

    Has anyone tried Gorilla Trades? I’ve been hearing a lot of buzz, and today, I was seriously considering membership.

    My mind told me to sleep on it instead of acting on impulse.

    Any feedback would be appreciated.

  9. Even at $5 per trade, she’s paying 1-2% round trip in commissions… something you might want ot mention to her. Chances are her transaction fees aren’t that low…

  10. I disaggree with your article.

    Your friend has what is called an insider tip about the company. If the tip is true, then she should invest and then sell the stock later. She doesn’t have to keep it for 20 years.

    For example recently I had a tip about a bank which was going to make an important announcement. I bought the stock and waited for the bank to make the announcement. The bank made the announcement. I waited for another 2 days for the stock to grow, and then sold it, and made 4X the money.

    That’s how insider tips work.

    However, they may be illegal.. the SEC doesn’t look at these with good eyes.

  11. Ramit Sethi

    Insider tips come from a senior executive at the company, not the manager who sits 2 cubicles away.

  12. What company did she invest in? I’d like to do the same. 🙂

  13. Chris Ellan

    Insider tips are illegal regardless of the manner. The SEC makes a rule book that oulines every aspect of insider trading and new laws have been passed in the last two years in order to council all speculaters who “think” they know what insider trading really is. Bottom line is, if its legal, its not an insider tip.

  14. Freelove

    If the person has not invested in any stocks before then the upside would be knowledge and experience in doing so. Perhaps by owning this stock (even a small amount) she begins casually reading the stock quotes, news stories, and maybe looks at an annual report or two. The increased knowledge and future confidence could very well be beneficial, though I fully agree that it is a bad idea to buy based solely on the “tip” of her manager.

  15. Ash Dyer

    I discussed this topic in a recent post, “Sniffing Out the Wannabes”. Sorry for the self-promotion, but I really believe in the message – a brief lesson in the people dynamic of market movement.

    I’ll also point out that if someone’s only telling you about their “hot stock” after they’ve been holding the position for three months then something’s wrong. They obviously aren’t interested in sharing profits with you or they’d have told you much sooner. At this point it’s just an ego trip.

  16. some body

    i disagree. let’s say you have two watches, one that is off by a few minutes, one way or the other (you just don’t know which way it is off). you have another watch that is broke. would you use the broke watch as it is correct at least twice a day, or the one that is never correct throughout the day? similarly, i – like your friend – will probably put a small portion of the eggs in my basket into this ‘tip’ and not all of them.

    – s.b.