This is a guest post by Eric Rosenberg, a full-time freelancer and blogger at Personal Profitability. Eric writes about personal finance and entrepreneurship at InvestmentZen, his own blog, and other sites around the web.
Who doesn’t want to jump into a sexy investment, see the stock price double or more, and brag about how smart of an investor you are? While everyone wants to be the next stock market millionaire with a quick win, exciting investments often underperform their boring counterparts. Here are some reasons to skip your next exciting investment idea in favor of something with a little less gusto.
Exciting Investments are Riskier
Investors often look at risk versus return when evaluating an investment. Risk is sometimes measured using beta, a measure of volatility compared to the market as a whole. Stocks with a high beta have more risk and a lower beta have less risk. Using beta and the capital asset pricing model, investors can measure an expected return for an investment.
If a stock moves exactly with the market, it will have a beta of 1. Investing in a stock with a beta very close to 1.0 indicates that it will generally move with the market. Higher betas could lead to bigger returns, but also bigger losses. Is the risk of a big loss worth it? In some cases it can be, but for most investors it isn’t worthwhile.
Exciting Investments May Be Overvalued
If you think an investment is exciting and has great potential, odds are someone else has the same hunch. In the age of the internet, there are probably lots of someones. News spreads around the world like wildfire, and your hot stock tip is probably out on Twitter, The Wall Street Journal, Seeking Alpha, The Motley Fool, and one of dozens of other investment sites.
If other investors are thinking the same thing, they could be piling dollars into the stock pushing the price higher and higher. By the time you are ready to enter your trade, the price could already have appreciated by so much that you are not getting a good deal.
If a stock is hot, you will most likely miss out on the “buy low” part of buying low and selling high. In that case, you won’t make much and the stock likely has a lot of downside risk built into the price. That is not a risk I would want to take!
Exciting Investments are Less Predictable
Exciting investments are fun to watch due to their volatility, but do you want something you can’t predict in your portfolio? I know that I would rather invest in a sure thing than something super risky.
The market overall is also not predictable, but over time has a predictable trend. While stocks go up and down based on their own performance and market whims, the market as a whole is much harder to move. We have seen big drops thanks to the Great Depression, Financial Crisis, Flash Crash, and other market or economy wide events, but in general the S&P 500 ticks higher and higher over time.
Over a long time horizon, the S&P 500 offers a 25 year annualized median return of 12.98%. That is predictability I can get on board with.
Boring Investments Offer the Best Payoff
Looking at all 25 year periods since 1970, the S&P offers compound annual returns ranging from 9.28% to 17.25%. Even after big events like the 2007-2008 stock market crash during the Great Recession, people were still making money if they were invested over a long enough period of time.
With that in mind, is it really worth chasing a bigger, riskier return from a sexy stock pick? Maybe yes, but only do so with “fun money” that you can afford to lose. For your retirement, college savings, and other important investments for your family, don’t gamble on a risky stock. Invest in something you can count on.