Beginners’ mistakes in investing: finding the next big thing

One of the most prevalent mistakes among people who have limited knowledge about the stock market and companies is that they think the (only reasonable) way of making money is to find the next Google or Apple before anybody else. Without doubt this is an alluring proposition. If one bought a 50% stake in Apple before its IPO, by now that investment would amount to probably tens, if not hundreds of billions. Sounds so very easy!

But why is then the world not full of ordinary folk who bought such stakes and became filthy rich?

First, because there are tens of thousands of start ups and identifying the winners is devilishly hard. Warren Buffett likes to give the following example: Imagine that you lived in the early 20th century and you predicted that the car industry was going to grow astonishingly (as it indeed did) in the US and the also worldwide. Which company would you pick, given that there were around 2,000 car makers in the United Sates? Not easy to pick up a winner from the list. You might have had a much greater chance playing the casino than betting on the right car maker. Similarly, today the future of the biotech industry looks bright but there are scores of small biotech companies. Some of them are probably going to do extremely well but trying to predict which ones is more of a speculation than true investing.

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The S&P 500 closes at record 1900: is it just a bunch of overeager bulls that drive up the market

This Friday, 23 May 2014, the S&P 500 closed above 1900 for the first time ever. Yet this is a bull market that almost nobody loves. So, what is driving the US stock market up given that so many investors remain pessimistic and that valuations aren’t exactly cheap? This was in essence the question Julie Hyman of Bloomberg TV put to John Manley, funds chief equity strategists at Wells Fargo. He answered something like: it’s those investors that are most eager to buy stocks that push prices up.

This answer implies that the valuations are wrong. It’s just a small portion of the investors that are really ready to buy so expensively. The majority are not. Now that is undoubtedly true. However, this situation is not unique to 2014. This is how it has always been. At all times it is the investors most eager to buy stocks that drive the quotes that we see on stock exchanges. These prices obviously do not reflect the price that would prevail should all (or at least a significant part of the) investors decide to sell at once.

This view misses also another important point: the price goes up or down not only because of the most eager buyers but also because of the most eager sellers. The fact that stock prices move up goes to show that there aren’t enough eager sellers at the current price. Why? Is it not because the holders of the assets are fundamentally optimistic and consider that current valuations are not totally out of touch with reality and indeed worth holding still. That would seem to be the case. Which implies that the overall market is sufficiently optimistic, not just a fringe of over-eager bulls.