A friend of mine calls me (I’m a Financial Advisor BTW) and says, “Hey Justin, I just read that Apple is coming out with the iPhone 5. We got to buy Apple stock. I think the stock is going to go up.”
I tell him what I’m thinking.
“Do you think that you are the only one that knows that the iPhone 5 is coming out!! Oh jeez. I mean come on now! The stock has gone from 580 to 600 on rumors of this announcement. Everyone and their mother knows about the iPhone 5 launch!”
My buddy buys the stock anyway at $600, and when the announcement comes, the stock goes down by $5. He’s pretty fahklempt. Has this ever happened to you?
A client calls me and says, “Justin, we gotta buy Tesla. They are coming out with a new model where you don’t have to fill the gas tank up for 1 year! It is going to be amazing.”
Oy vey. Here comes another fahklempt situation (yiddush for overly emotional)
What he doesn’t realize is that this new Tesla model has been expected to be released for months. Again, I’m thinking – Do you think that you are the only one who knows this info? This news has got to be factored into the stock. Hello!
Isn’t this why Tesla stock went from 80 to 100 in the first place? Because of the fact that the new model would drive sales higher?
Now my cousin calls me. “Hey Justin, we need to buy Time Warner stock. The next Harry Potter movie is coming out. They could do $200 million in movie ticket sales this weekend. Time Warner is going to make a killing.”
Again, my cousin doesn’t realize that this news is the reason why the stock has already gone from $50 to $55. He is about as sharp as a bowling ball.
So what’s really going on here? What’s the dealio?
It’s all about information, and whether this info has or hasn’t been factored into the stock.
Lemme give ya the birds and the bees, the down low on how information affects stocks.
We all kinda know what inside information is. It’s when someone gets a hold of some top secret info. Info from a company insider like an officer or key employee. Info that could affect a stock price or any other public security for that matter. This info hasn’t been released to the public yet. It hasn’t been posted on a newswire, or on CNBC, or even Twitter.
People talk. This stuff happens all of the time and it is illegal.
Here’s a total hypothetical example. Hank owns Hank’s Hot Dogs. It’s a public company. The stock is at $15. Hank has now figured out how to make a zero calorie hot dog. The public doesn’t know about this yet.
The VP of Operations at Hank’s Hot Dogs tells his friend Mike about the zero calorie hot dog before they release the news to the newswire services. Mike goes out and buys stock in Hank’s hot dogs. Mike then tells his cousin Vinny (Joe Pesci?) who then tells a cab driver. The cab driver tells a big hedge fund manager and the next thing we know the stock is at $18, because of all the buying pressure.
Then Hank announces the new hot dog via a public news service like Dow Jones newswire, and the stock goes to $21!
As soon as inside information becomes public information, it immediately (within minutes, even seconds,) becomes factored into the stock.
Here’s the deal. Stock prices are usually efficient. That means that once the info is out there, it’s usually factored into that stock.
Take it from Gene Fama. He was one of the 3 guys that won the Nobel Prize in Economic Science a few weeks ago.
Fifty years ago Gene Fama came out and said that stock prices – on a short term basis – are unpredictable and go on this “random walk.” It’s hard for investors to try and game stocks short term. Fama just won a Nobel prize on his research he did in the 1960’s…! He did research 50 years ago and just won the Nobel! For reelz.
Fama’s research was the engine that got the index funds going. That’s the whole theory that it’s very hard for investors to pick stocks that will beat the market.
So the next time you think you want to buy a stock because you think you’re on to something or have a hot tip, ask yourself these 2 questions:
- Is there any way that someone else already knows what I know? Is this stuff already factored into the stock price?
- Am I trading on non-public inside info? If you think you are, don’t take any action. It’s illegal and even the little guys can get busted.
It can be very hard to pick a bunch of stocks for your portfolio. It may make sense for you to consider investing in mutual funds which may offer some diversification.
Oh, and one more thing, there is a whole emotional component on investing. It has to do with how we make decisions about money. One of them is what we’ve been talking about here. Overconfidence. Just Google “overconfident investing.” That’s your next step.