If you're like most investors, you've had the unpleasant experience of hearing about a hot company that's destined to disrupt everything, only to buy the stock and see its price fall expediently. And without a fundamental change in your investing perspective, it won't be too surprising if you keep experiencing the same results again and again.
Don't worry: There's hope for a more-profitable investing life ahead. But especially when it comes to investing in growth stocks, you'll need to get into the habit of doing a bit more due diligence before taking the plunge.
Let's explore why your growth stocks keep falling as soon as you buy them, and what you'll need to do differently to effectively invest in them.
Stop falling victim to the hype cycle
Let's start with an example of a growth stock that went down right after a ton of people bought it. Remember Teladoc Health (TDOC -2.91%)? The telehealth company became a household name overnight in 2020 due to the pandemic's constraints on in-person healthcare visits.
Its shares grew by 138.8% in 2020, and with good reason: Its quarterly revenue also rose by 145% year over year as millions of people subscribed to its platform or were members of healthcare plans that offered access to it as part of their coverage. People who owned the stock before 2020 got a lot richer, but new investors didn't have nearly as much luck after that run-up.
If you invested at the start of 2021, your shares would have fallen by 54% by the end of the year, driven in part by the declining pace of revenue growth, which led to quarterly sales climbing by "only" 44.5% that year. And if you were unlucky enough to buy shares right at their peak in the first part of the year, your losses are likely even more severe. But the good news is that such bad results are (almost) entirely avoidable.
There are a few problems at play in this example, starting with the fact that Teladoc's whip-quick growth in 2020 was absolutely unsustainable. Without a catalyst similar to the onset of the pandemic happening each year, there's simply no other economic or business forces that could drive new members to Teladoc's platform by the millions.
Many investors probably didn't think about that, and instead focused on the ability of the business to continue to scale by virtue of being a leader in the emerging market of telemedicine. They might be right, but it'll likely take years for their shares to be above sea level again if they ever are.
Image source: Getty Images.
The lesson here is to shed assumptions about a business' current growth rates continuing forever, especially when revenue is expanding extremely speedily (above 30% per year). If you make those assumptions anyway and they prove to be incorrect soon after your investment, don't be surprised when your shares fall. The faster the growth rate, the more likely it is that there will be (at least) a speed bump coming soon.
There's nothing wrong with Teladoc as an investment today; it's just that during 2020 and early 2021, the short-term future was practically destined to be less rosy than the recent past, so new investors at the time were somewhat doomed.
The next issue with the Teladoc investment in 2020 is that skyrocketing share prices tend to create a stir, and that attracts investors on the margin. Those investors might not know much about the company issuing the stock, but there's no rule that says you need to be knowledgeable to invest, so they bid it up, making sure to tell their friends about the quick money to be made.
Without a solid investing thesis, it's very difficult to have the conviction to hold shares through a dip or downturn, since there's no mental clarity about what might be a catalyst for a recovery or growth in the long term despite short-term share price movements.
So, low-information investors tend to sell out of a stock just as quickly as they pile in, which is likely another part of what happened with Teladoc. The takeaway is that you should be picking your investments based on your assessment of a company's ability to generate value and compete successfully in the long term, not based on a tip someone gave you -- and not based on its price performance over the last few weeks or months.
Keep your eyes on the long-term investing thesis
Your growth stocks keep crashing right after you buy them because you're (probably) not buying them using a sound investing process in the first place, thereby leaving yourself exposed to losses everywhere you turn. Avoiding that requires some research about the company you're thinking of buying to determine what its realistic prospects are in the long term. And it requires being willing to walk away from a stock if it's on a tear as a result of intense media coverage or perhaps meme-trader activity.
If you get a tip from your friend, it's fine to use that as a starting point for your diligence. Just don't let it be the diligence itself, because that's exactly the situation where you'll lack the understanding of the business' strategy and the conviction in your investing thesis to hold through a downturn if it occurs.
Lastly, don't be too hard on yourself if you develop a good process and then your next growth stock still takes a tumble right after you buy it. The bear market is a brutal time for growth stocks, and nobody can predict exactly which way they'll turn, even with plenty of preparation.
