According to Michael Lewis, one of the standard ways in which a stockbroker tries to sell a stock to a small investor is by invoking the hallowed name of Warren Buffett. The intuition is clear: Warren Buffett became a multi-billionaire by picking great stocks. If you pick the same stocks as Warren Buffett, you too could get rich.
Abnormal Returns has a name for this kind of thinking: “coattail investing”. And as they point out, it’s a very bad idea.
We have written previously why investors should examine their own investment process before wholeheartedly embracing this approach of ‘piggyback’ or ‘coattail’ investing. A recent article in the Wall Street Journal by Dana Cimilluca illustrates how some large investors have been burned trying to bottom fish recently in the financial sector. The subprime mortgage fiasco and the subsequent credit crisis has made a number of supposedly smart investors look pretty dumb.
The danger for individual investors is evident. If you had blindly followed the so-called ‘smart money’ into any number of financial stocks in the past couple months you would in all likelihood be sitting on unrealized losses.
As a general rule, it’s a really bad idea to invest in a stock because some other investor, whom you think is very clever, is investing in that stock. For one thing, you have no idea what their hedges might be. For another, you have no idea what their exit strategy is. And more generally, the chances of your risk profile being the same as their risk profile are minimal.
The vast majority of individual stock pickers, I think it’s fair to say, overestimate their own risk appetite, or underestimate the risk in their portfolio, or both.
And yes, it is possible to overestimate your own risk appetite, just as it’s possible to overestimate your own hot-dog appetite. People regularly think they have more room for food/risk than they actually do. One good way of judging a financial advisor, indeed, is to see whether he says things like “you might tell me you want 15% returns, but in fact you want lower returns than that, because you can’t afford to lose the kind of money which you’ll be risking if you aim for 15%”. It’s the kind of statement which ought to be made much more frequently than it actually is.