Why Chasing Stocks You Like Won’t Make You Rich
By Kayla Barzideh
Disclaimer: I am not a certified financial advisor, and this article does not constitute financial advice. Instead, this article reflects my personal views as a student of investing.
At first glance, investing in the stock market might seem fun and simple: find the companies you like or admire, buy their stocks, and watch your investments grow. But unlike choosing how to dress yourself, investing based on brand names or personal tastes is not the best way to build long term wealth in the stock market.
One of the most important and fundamental ideas in investing is understanding price versus value. The stock of a great and popular company can still be a poor investment if that stock is overpriced. This can happen when many people buy the stock of a company simply because they like the company, regardless of how earnings have been trending in comparison to the stock price.
When too many people chase a stock, demand for the stock pushes its price beyond what the company is reasonably worth. That means new investors would be paying a premium, which lowers their potential returns. Instead, investors should focus on buying stocks whose price is lower than the actual value of the company today. We will address how to estimate the value of a stock in a subsequent article. For now, just understand that the stock price and the value of the stock are two separate things, and the goal of investing is to “buy low” relative to that calculated value, and “sell high” relative to that calculated value.
Even if you have calculated the “cheapest” stock to buy and invested in it, there are no guarantees in life – or, as they say in investing “there’s no free lunch”. Investing is inherently risky, and that risk can come from many sources: changes in company earnings, management, or competitive industry dynamics, to name a few. This is where diversification comes into play. Instead of betting your entire savings on one individual stock, the best way to manage risk is investing in many stocks at one time. This way, if something goes unexpectedly wrong for one company, it does not have an overwhelming negative impact on your portfolio.
There are many ways to achieve diversified investing. You could in theory evaluate all the stocks in the investible universe and pick your 50-100 “cheapest” stocks to invest in. I know what you are thinking: “this is a lot of work, and I have a day job”. Thankfully, there are prepackaged portfolios that you can buy as well. They are called “indexes”. Better yet, these indexes have other benefits that we will discuss in subsequent articles on the topics, including the impact of fees on long-term investment returns, and the benefits of “passive” versus “active” investing.
For now, just know that you are taking a very important step in securing your long-term financial future. You are investing your assets wisely, not by chasing fads, but rather by understanding the benefits of “price versus value” and “diversification”. These ideas connect to deeper concepts in investing known as the Efficient Frontier and Efficient Market Hypothesis. In simple terms they relate to the idea that successful investing is not about finding a single hidden gem, but about controlling risk versus return through diversification. In future articles we will explain this concept more fully and its ramifications for your approach to investing.
