The Peak of My Delusion

Investing in single stocks can be exciting, but they can also be hazardous to your financial well being.  Here is how I learned that lesson the hard way.

It was the late 1990s, and the stock market was booming.  You had to try not to make money.  I was at the peak of delusion, the most extreme point of self-deception. My skill in picking stocks was the catalyst of my good fortune.

During this period, I gained quite a bit of knowledge about automatic test equipment while working for the Government, and I thought I could use that knowledge to find a great investment opportunity within that industry group. I found a small company I thought had an edge.  After submitting the necessary disclosure to my employer, I invested somewhere around $80K in the company’s stock (which will remain unnamed), quite confident it was going to make me a fortune.

The price began to drift lower and lower, but being the “knowledgeable” person I was, remained confident I would eventually be vindicated.  Then one day the stock just collapsed, losing around 50% of its value in one day.  What the hell?  I quickly pulled up the news, and learned their offices had been raided by the FBI.  Why?  They were suspected of selling equipment with technology under export controls.  That means the technology they were using required prior Government approval before they could sell to restricted foreign countries.  They were suspected of making sales without getting the approvals, thus the raid.

I thought it was just a setback.  When the dust settled so to speak, things would return to normal.  The stock continued to tank. I made plans to visit their corporate office to find out what they were going to do about fixing this mess.  I was traveling to the general area anyway, so a side trip would provide an opportunity to investigate the situation directly. It took a couple hours by rental car to arrive at the near-unoccupied office/warehouse.  There were just a few people, no CEO available, nor anyone willing to talk with me.

I sold the stock. I think it was around an 80% loss. It felt like total failure.  Even though there was no way to know this could happen ahead of time, I felt like a fool for putting so much into just one stock.  My wife was very understanding.  She knew I was in pain and punishing myself enough, so she probably did not want to pile on. She encouraged me to learn from the mistake.  It is a bit difficult to explain just what it feels like to lose a large percentage of your net worth so quickly when a stock tanks.  First there is shock, a tingling in your head, then a whole mix of emotions: denial, bewilderment, fear, and anger.  Then, there is the realization you made that choice.  All of this hits you within a period of about five seconds.

So I learned the hard way about single stock risk, or what Larry Swedroe calls “uncompensated risk.” The thing is, the whole situation could have been easily avoided just by diversifying. Contrast the single stock approach with index funds, built using broad market indices. They enable investors to eliminate company-specific risk.  Yes, there is still a lot of risk because, after all, it is the stock market, but index fund investing limits you to the market level of risk. Today, Apple Computer has the highest valuation (market capitalization) of all US public companies, yet it accounts for about 3% of the total stock market index.  If for some reason Apple were to drop by 50% in one day, it would cause the total stock market index to lose just 1.5%. Assuming you have a balanced portfolio that includes bonds, your price change would be even less.

Markets are efficient, but I thought I was smarter.  After all, I had made a lot of money during the 90s, and was also educated in finance.  I reasoned that my prior success was because of my talent for picking stocks, not because we were having the biggest bull market since the 1920s.

I had special knowledge and information no one else had. I was at the peak of my delusion. Even reading Burton Malkiel’s “A Random Walk Down Wall Street” in the 1980s was not enough to stop me. It took this very painful experience before I could accept that concentrated investments can be hazardous to my wealth.