It can be worthless no matter how much you paid (though not negative with limited liability
). Here, buying just because the price is high is a typical pattern.Stocks represent partial ownership of a business. The value of the business is primarily determined by future activities, but the price is determined by the supply and demand of the current market. For example, if a business is perfectly stable with $100M net yearly earnings and a $1B asset, the value would be similar to 10% fixed-income bonds
. However, business is much more dynamic with many variables in revenue, cost, competition, vulnerabilities, etc., making the valuation of stocks much more subjective.Sometimes, the price can be much higher than the value, but this is when we are most tempted to buy them because FOMO (fear of missing out) is firmly ingrained in our brains. Moreover, bubbles are hard to tell until they burst, and we continuously see examples of catastrophes like Tulip mania in the 17th century, the 2008 subprime mortgage, and several coins this year. However, if you are too hesitant, you will miss great opportunities like Amazon in 2010 or Tesla in 2013
. Simply because forecasting the future is impossible, even the most successful investors can fail to distinguish bubbles and gems.To mitigate risks, we should admit that we will never be perfect at forecasting the future and choose an investment strategy that fits each circumstance. In the end, a bigger risk is getting too anxious about your investment hurting mental health or spending too much time looking at charts. There are a few tactics that can help (they lower wins of upside, but also lower losses of downside):
- Spread transactions across a longer horizon: Even If you found an excellent opportunity, consider purchasing only a portion at fixed intervals to minimize the impact of a single transaction (e.g., 20% on the 4th day of each month for the next five months).
- Be wary of leverage: If you leveraged 5x, your position would be wiped with just by 20% loss. Even if you are right long-term, your investment would be worthless due to hiccups.
- Only use the money you don't need in the next 3-5 years: It can take a long time even for a great business to get appreciated by the market. If you are forced to liquidate the position early, the upside would be limited even if you chose a good firm.
- Diversify positions: Even fabulous companies can go out of business due to surprising events or a strong competitor (like Yahoo! In the 2000s). So, it would be safer to assume that a single company's stocks can substantially reduce the price at any time and be prepared for such events. I've been using Wealthfront for diversification for >6 years (here's affiliate link), which seems to work reasonably well, covering beyond US stocks with minimal hassles and low fees (plus, tax harvesting can be powerful).
Despite risks, stocks have been performing better than other financial assets (though it doesn't guarantee the future), so it still looks reasonable to include stocks in your portfolio.
Footnotes