Fool.com: It's Fun, But Is It Investing? (Fool on the Hill) November 16, 1999

FOOL ON THE HILL
An Investment Opinion

It's Fun, But Is It Investing?

By Warren Gump (TMF Gump)
November 16, 1999

"Hey Billy, I just came into some money. What should I do with it?"

"Well, there are several options. You could do something really easy like buy an index mutual fund that gives you exposure to the entire equity market. The returns there have been OK (20%+ annually over the past few years if you chose a total market or S&P 500 fund, well above the historical trend), but there are some other ways to make a lot more. One strategy is to buy big-name tech stocks like Microsoft (NYSE: MSFT) or America Online (NYSE: AOL). They've returned well over 50% annually for the past five years and you basically can't lose. If you really want to make some money, though, you probably want to catch one of those newly public telecommunications infrastructure companies right after they come public.

"I bought some Juniper Networks (Nasdaq: JNPR) right after it came public for $100 per share. Some people said to stay away because the price was four times the $25 initial offering price, but I felt it was going to be big so I bought the shares anyway. Less than six months later, I have shares worth $300 each! Since that one worked so well for me, I bought some Foundry Networks (Nasdaq: FDRY) for $145 two days after its public offering (at $25 per share). A month and a half later, they're worth $175 each. I think this is really the way to make good money in the market. I'm using one of those Web services to get the name of every IPO coming out and pick up any that rises more than 100% on its first day."

How often have you heard this type of conversation? The words might differ, but the gist is the same: Someone has found a seemingly guaranteed way to make huge profits in the market. A few years ago, these conversations were confined to select, elite cocktail parties. More recently, they are popping up everywhere: the people in line at your local Starbucks (Nasdaq: SBUX), at the table next to you in McDonald's (NYSE: MCD), in the home improvement section of your local Borders (NYSE: BGP) bookstore, at the beginning of your step aerobics class, and in the Laundromat as people wait for their clothes to dry.

The first few times you hear other people's extraordinary stock success stories, it's painless to shrug them off as flukes. Someone got lucky a couple of times, but chances are that such success will not be replicated in the future. You're going to stick to your index mutual fund investments, comforted that many intelligent people concur it is a sound strategy. Then, stories about other people's success become more prevalent. One of your coworker's kids buys a new house with the proceeds from his successful two-year investing stint. Your hairstylist raves about his three-week trip to the Bahamas, made possible with the profits from a stock he bought on the recommendation of a customer who works with a technology firm.

As these stories accumulate, your investing strategy appears increasingly deficient. The 20% or so returns being earned are OK, but they pale in comparison to the 40%, 60%, and 80% gains everyone else seems to be enjoying. When you find out that your 24-year-old neighbor Sarah purchased a shiny new silver BMW Z3 with profits from investing in some Internet companies, you decide that action is necessary. You aren't going to be satisfied with the measly returns from the index funds... you're going to join the big leagues and pick some individual stocks.

Your better friends are actually excited about your move into picking individual stocks. They have been picking stocks for years in an investment club and believe investing is a fun and profitable hobby. They invite you to join their club, but you pass due to time constraints. When asked how to pick stocks, they suggest finding companies that make things you know and understand. Pick up that company's annual report and learn about the company's products, its history, and the industry in which it's involved. After that, compare and contrast that company's business model, financial structure, and growth opportunities with its competitors. Once you find something that is promising, take the plunge and buy some shares.

Based on this course of action, the investing process comes across as being tedious and time consuming. You figure out that there must be an easier way to achieve investment success. When you're outside raking leaves one day, you see Sarah jumping out of her Z3 and ask her how she goes about picking stocks. She says that it's really easy. Her strategy is to find companies involved with the Internet that have "strong charts." She looks for stocks that have at least doubled over the past three months and are reaching new highs on heavy volume. According to Sarah, these stocks almost invariably go higher. This strategy sounds easy to execute and it's sure to be much more profitable. After all, your friends' investment club only earned three percentage points over the market during the past two years.

Slightly fearful of losing your nest egg accumulated over the past 20 years, you decide to tiptoe into Sarah's strategy using only 10% of your assets. You find two companies meeting her criteria and split the money between those stocks. Both stocks are winners and you're sitting on combined gains of 38% after two months. This superior performance has persuaded you to allocate all of your funds to this strategy. You tap into your Internet broker and sell all of your index mutual funds. When shuffling through the broker's website to get to its charting area, you learn that you are eligible for a margin account that will let you borrow money against your account to buy even more stock. With the returns you're planning on achieving, taking advantage of this option seems to be a no-brainer. You start envisioning owning your own private island, like the truck driver in that broker's commercial.

I hastily interrupt the above piece of fiction, which is an amalgamation of personal experience and stories picked up from others. The time is today, with a significant number of investors holding stocks because they have recently been good performers. Due to its success, people are increasingly finding this stock screen to be more effective than evaluating a company's underlying business and incorporating reasonable expectations about its future prospects.

Only time will tell what happens to these investors. Perhaps they are correct and investing in the stock market is like selecting the prom king and queen, where the most popular ones win. That certainly seems to be a common belief. What happened to your high school prom king and queen? Did they end up being the most successful people from your high school 10, 20, or 30 years later?

On a totally unrelated note, anybody wishing to read The Hare and the Tortoise fable can purchase it up for $3.16 (plus shipping) from Amazon.com (Nasdaq: AMZN).