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In the fast-paced world of investing, the allure of chasing popular stocks can be tempting. The promise of quick riches, the thrill of riding market momentum, or the opportunity to be an early investor in an emerging growth story often draw investors into the realm of stock speculation. However, the endeavor is fraught with risks, uncertainties, and challenges.
The recent fervor over “AI” stocks is stirring much debate. The possibilities for artificial intelligence are limitless, and I don’t pretend to understand the full implications for both the positive aspects and the negatives (I’m hearing a lot of Skynet references these days 😊). However, AI stocks have seen a rapid price increase this past year as investors are excited about the investment opportunities that AI might bring about. To illustrate some important points for investors, I’m going to pick on Nvidia, the darling of the AI story, which has experienced another meteoric rise in its relatively short history.
Let me be clear, I make NO predictions about the trajectory of Nvidia’s stock, both in the short-term or long-term, or the AI/tech industry. I am only using Nvidia as an example to show investors that if you want to invest in popular stocks, or stocks that have experienced a rapid price increase, you need to understand the challenges you face and that it’s best to have a plan.
The Phases of a Rise and Fall
The rapid rise and fall of a stock typically go through several identifiable phases, which can be characterized by investor sentiment and market dynamics. Here are the general phases:
Initial Increase in Stock Price: During this phase, a stock experiences a steady increase in its price, often driven by positive news, sector outlook, strong earnings reports, or some other favorable condition. Investors become increasingly optimistic about the stock's potential for growth, leading to heightened demand and rising prices.
Euphoria and Over-enthusiasm: Speculative buying increases, often fueled by the fear of missing out (FOMO), and the stock may enter into overbought territory. As the stock price continues to soar, investors may become overly optimistic and exhibit irrational exuberance.
Peak and Saturation: The stock reaches a peak price, signaling a point of saturation where demand begins to wane. Some investors start to take profits, while others continue to buy in hopes of further gains.
Sudden Downturn: A catalyst, such as negative news, poor earnings, or a broader market correction, triggers a sudden downturn in the stock price. Panic selling may ensue as investors rush to offload their shares, leading to a sharp decline in price.
Capitulation and Despair: The stock experiences a significant decline, causing widespread pessimism and despair among investors who may have suffered substantial losses. Many investors sell their positions, often at a loss, contributing to further downward pressure on the stock.
Stabilization and Recovery: The stock price stabilizes as selling pressure eases, and value investors may start to see the stock as undervalued. The stock may begin to recover as bargain-hunters and long-term investors step in.
And, the cycle repeats.
Understand the Past to know the Future
Stocks go in and out of favor, often exhibiting the life cycle described above perhaps many times during their history. Nvidia has gained a lot of attention in the past year due to its dramatic rise, but this isn’t the stock's first rodeo. Nvidia has had many instances of swift gains followed by spectacular drops, each time creating gut-wrenching thrills and spills.
Here are a few examples.
Nvidia 1999 to 2002. 1,634% gain followed by a 90% drop.
Nvidia 2004 to 2008. 1,181% gain followed by an 85% drop.
Nvidia 2018 to 2021. 1,020% gain followed by a 68% drop.
Nvidia 2022 to present. 800% gain, and then...
Where is Nvidia’s stock headed from here? No one knows. Will it double in 6 months? Maybe. Drop by 50% by the end of the year? Possibly. But one thing is clear, if you are going to invest in a stock that’s up almost 800% in a little more than a year, you’d better have a plan.
Considerations for Chasing any Stock or Sector
Even if an investment has great long-term growth potential, is it possible investors are getting ahead of themselves?
In the graphs above, would you have known when the stock peaked? When would you have bought or sold?
If you’re going to invest in a stock or sector in a frenzied state, do you know when you’ll get out? Will you set profit targets, stop losses, or watch your investment go up in flames? Would you be able to tell the difference between a pullback and the start of a major selloff?
Even if you are buying for the long term, would you have held on during the crashes?
How much money will you invest? Timing the market is extremely difficult and losses are common.
Is it worth the risk? Do you even need to take the risk to meet your financial goals?
If you work for a public company whose stock is experiencing rapid price appreciation, and you have stock or equity compensation that is deep in the money, make a plan for capitalizing on your good fortune. I have heard horror stories of employees waiting for their highly appreciated shares to go even higher, only to watch millions of dollars of value disappear.
When popular stocks drop, many people lose money. It’s OK to sit on the sidelines if you don’t want to be one of them.
There's An Alternative
I’ve learned many things throughout my career, and one is never to call a top or a bottom. Prices can, and often do, go higher than one would expect and lower than one would expect. Fortunately, as a proponent of having a diversified portfolio and a systematic process for investing and rebalancing, I don’t have to play the game.
Globally diversified investors, those holding broad-based mutual funds or ETFs, have already profited from the AI boom, and Nvidia, and will continue to do so if the growth story continues. However, if the hype fades, or the growth story takes longer to come to fruition than some expect, that’s OK because their portfolio has exposure to other stocks, sectors, regions, and asset classes, all of which may be experiencing their own “story.”
This offers the investor something that a single stock or sector cannot, and that’s diversification. They won’t be wiped out the next time Nvidia’s stock takes a dive, and they don’t have to worry about timing it just right. And, if they have a disciplined process for rebalancing their portfolio, then they have a systematic process for buying low and selling high and keeping the risk of their portfolio in check.
Conclusion
For those looking to capitalize on the next hot sector or stock, or who are experiencing a case of FOMO, it’s crucial to understand the boom-and-bust cycle a stock may exhibit. By recognizing the hype and emotional triggers, informed investors can avoid the pitfalls of irrational exuberance and navigate the markets with greater insight. And, with proper planning, you don’t need to wager your hard-earned money on stock speculation. A diversified portfolio will chug along year after year, giving you a much better chance of reaching your long-term financial goals.
As always, if you have questions or concerns regarding your investments, be sure to speak to an investment professional who can help you create a plan suited to your needs and situation.
Tad Jakes, CFP®, EA