How Does the Average Investor Invest Rationally in an Irrational World?

My own children’s experiences and all that’s happened with Bitcoin and GameStop recently got me thinking: Investors need to keep their greed in check and make sure they’re investing, not gambling.

By Jamie Letcher, CRPC®

published 28 April 2021

in Features

(Image credit: Getty Images)

A few weeks ago, I received two text messages from each of my children (ages 24 and 20) 15 minutes apart. One asked for my opinion on the stock market. The other asked what he was supposed to do with a tax document he received from Robinhood, the trading app. It was a red flag to me, and we had an important discussion about what IS going on in the markets.

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Unless you’ve been asleep the past month or so, you’ve likely wondered what is to make of investments like GameStop or Bitcoin. These investments have been extremely volatile, and it’s hard to understand how that volatility can be reconciled with reality. In short, I would suggest that oftentimes, it can’t.

The Rise and Fall of GameStop

The GameStop story was compelling: The price of the stock was driven up swiftly and dramatically by a horde of small investors communicating on social media. The run-up of the price led large professional investors (i.e., hedge funds — the so-called “smart money”) to bet the value of the stock was overpriced, and it would soon fall. This is called “shorting” in Wall Street parlance, and a classic David vs. Goliath standoff that took place over a few weeks. For a period of time, the small investors clearly won, and they drove some of the hedge funds to exit their positions and accept a loss … a defeat.

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Many hailed it as the small investors winning, and while many no doubt profited handsomely, I suspect an equal number incurred economic pain with the inevitable return to earth. According to WSJ Markets data, on Jan. 11, 2021, GameStop was priced at $19.94/share. On Jan. 27, it topped out at $347.51/share, but on Feb. 4, it was down to $53.50. That is an irrational swing all investors should take special care in scrutinizing, and it’s prudent to avoid allocating anything more than a sliver of a portfolio to it. If you choose to go down an investing path like GameStop, invest only what you can afford to lose.

And What Explains Bitcoin’s Allure?

Bitcoin’s ascent has been more of a slow-moving one, but similarly stunning and volatile. In April 2011, one Bitcoin was valued at $1. As of mid-April, it was priced at more than $60,000/Bitcoin, but the fluctuations each day are considerable. Cryptocurrency may be gaining traction in the elusive pursuit of respectability and, more importantly, usability.

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I have always been mystified by the attraction of Bitcoin. If I own a Bitcoin, how do I use it to make a purchase? And if I did have a debit card accessing Bitcoin, would I even use it with the wild swings in its value? Tesla has said they may begin to accept Bitcoin for purchases, and BNY-Mellon, the oldest bank in the country, has said they are looking into acting as custodian for Bitcoin for some investors. Those are two material developments that may add to the “respectability” question. Still, my advice to the average investor would be the same: Tread carefully here as well, and only invest what you can afford to lose.

How I Learned as a Child Never to Gamble

When I was in the fifth grade, our church had a summer festival to raise money. They had games and food and beer. Surprisingly to me, they welcomed me to a game-of-chance table. (The beer tent? Not as lucky.) I had allowance and savings from shoveling snow, so I thought, why not? In fairly short order, I lost what was in my pocket. Undaunted, I ran home to empty the piggy bank. As I flew out the door, my mother asked what I was up to. I sheepishly explained what was going on, anxiously fearing her response. After a verrrry long pause, she unemotionally said “good luck.” I asked myself: did she really mean it? Or was she really upset with this entrance into the adult world of chance and vice?

Well, you can guess how it played out. The piggy bank was lost in the span of a few hours. She never asked – she knew by my demeanor. To this day, gambling just raises my blood pressure. A life lesson was learned, and delivered by a wise mother.

Don’t get me wrong. We don’t need to and should not approach investing as if it’s gambling. Over the long run, we can have a high level of confidence we will achieve reasonable returns with commensurate risk. However, there have always been times where a significant blurring takes place between investing and gambling. The aforementioned are modern day examples. Go out and Google “Dutch Tulip Bubble” or the “Great British Bicycle Bubble.” There will always be greed. Our psychological and emotional challenge is how to recognize and temper it.

As for my children, it was a reminder to me that most kids are ill prepared for investing and financial management coming out of school. It’s a process, not an event, and it is incumbent upon all of us to educate them on what can be a complicated world out there.

Be well, and happy investing!

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Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Jamie Letcher is a Financial Adviser with LPL Financial, located at Summit Credit Union in Madison, Wis. Summit Credit Union is a $5 billion CU serving 176,000 members. Letcher helps members work toward achieving their financial goals and through a process that begins with a “get-to-know-you” meeting and ends with a collaborative plan, complete with action steps. He is a member of FINRA/SIPC, a registered broker-dealer and investment adviser.