Learning from the mistakes of trading speculative stocks

Every so often, speculative stocks become popular in the market.

This phenomenon is happening again. Note that in January, non-index names accounted for 71 percent of the top 15 actively traded issues in the Philippine Stock Exchange, up from less than 10 percent normally.

Although I already shared my thoughts on how to minimize risk while trading speculative stocks twice in the past (“How to minimize risks when buying speculative stocks”-Sept. 2, 2019; “Some tips when speculating in high flying stocks”-June 22, 2020), I would now like to share the mistakes of trading speculative stocks. These are lessons shared to me by experienced traders who learned the hard way, by losing money while dabbling in speculative issues.

Believing that “this time it’s different.”

A lot of traders lose money repeating the same mistakes when buying speculative stocks because of the belief that this time is different. They tell themselves that the speculative stock they own can justify a much higher valuation because the company they bought is engaged in a new economy business that will benefit from the new normal or that it is going to be bought by a very rich and successful businessman who will turn it around.

Although these beliefs could be true and the speculative stock that they own could be the next Amazon.com, which is now one of the most valuable stocks in the United States, it is important to note that Amazon fell by more than 90 percent from its dotcom bubble peak before going up again. Moreover, it took 10 years for Amazon’s price to finally break above its 1999 peak because it took time for the company to become profitable enough to justify its very expensive valuations. Finally, while Amazon became very successful, there were hundreds of other dotcom stocks that became bankrupt. This implies that there is a greater chance for a speculative stock to become worthless than to become the next Amazon.

Averaging up and averaging down.

When speculative stocks go up, fear usually turns into greed, causing many traders to buy more on the way up. Because of traders’ much larger investment, they lose more when prices go down.

On top of that, some traders average down when speculative stocks correct. Traders who do this think that the correction is only temporary. By buying more when the stock goes down, they can make more when the stock resumes its uptrend. Meanwhile, traders who are already losing money think that they can recover their losses faster by buying more on the way down.

However, it is very hard to predict when or where speculative stocks will bottom. Buying speculative stocks while they are going down is like catching a falling knife. Moreover, a lot of speculative stocks that go down take a very long time to go up. Sometimes, they never go up at all. As a result, investors who average up or down end up owning a huge position in a losing stock, magnifying their losses instead of their gains.

Believing in the greater fool theory.

According to the greater fool theory, it is possible to make money by buying stocks, even if they are not fundamentally sound and overvalued, because there will always be a greater fool who is willing to pay a higher price.

Although a lot of traders know that speculative stocks are risky and not worth the price they are trading at, they still buy them, thinking that they can sell their stocks eventually to a greater fool. And instead of selling on the way up, traders plan to just wait until their stocks show signs of weakness before exiting. That way, they can maximize their gains because prices of speculative stocks could still go up significantly before peaking.

Unfortunately, almost everyone who trades speculative stocks believes in the greater fool theory. As such, buyers disappear when prices start to show signs of weakness. Moreover, when the stock weakens, there is usually a stampede of sellers, making it virtually impossible to sell at a good price. Given the absence of buyers and the abundance of sellers, some speculative stocks hit the Philippine Stock Exchange’s static threshold of 30 percent for several days leading to huge losses for traders who still own the stock.

Although I don’t advise people to buy speculative stocks, I hope that those of you who enjoy the excitement of trading speculative stocks will learn from the mistakes I shared here so that you will avoid committing the same mistakes and losing a lot of money. INQ