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Why buying speculative stocks often proves irresistible

One small bet on a speculative stock isn’t so bad, right?

I’ve seen all sorts of “next big things” over the years—before I knew better, many of them were in my own portfolio! Early stage biotech. Junior gold miners. Fledgling software companies. Near-bankrupt retailers primed for a turnaround. Revolutionary medical equipment manufacturers. The list goes on and on. The most speculative of them are often called penny stocks, but they can be priced far higher than a dollar. The principle is the same. I’ve seen these companies trading for hundreds of dollars per share and still retain the spirit of the penny stock.

Low stock prices seem to draw people. As the thinking goes, it’s easier for a 10-cent stock to go to a dollar than it is for a 10-dollar stock to go to a hundred.

No matter what the market price of the stock, if there’s one thing all of these companies have in common, it’s a dream of multiplying your money several times over via a great story, a promotional management team, and promises of vast riches.

Let’s call them 'lottery stocks'. They’re close cousins to the venture capital lottery tickets we talked about earlier—the promise is that this one investment could change your life.

Why it doesn't work

But historical evidence tells us that these high-risk gambles, on average, don’t pay off. There’s no definitive reason for this to be the case, but my own theory is that the lottery ticket aspect of these stocks makes them extraordinarily attractive to speculators, which means their value gets bid up higher than it should. For some reason, this is often worse with the lowest-priced stocks. (And if you doubt this, ask yourself if you would stop yourself from buying a stock if it cost you 11 cents a share instead of 10 cents a share, and then ask yourself if you would do the same for a stock that was $110 versus $100. We rationalize away the cent as meaningless, even though the difference in both cases is a 10% premium.)

So let’s say you’re behaving yourself, holding a portfolio that is 98% made up of intelligent, blue-chip, quality companies. You’d like to gamble with that last 2%.

And I won’t stop you. I’ve done the same. But before you go ahead with it, consider the potato chip.

When’s the last time you had just one?

You see, the lottery stock purchase is a lot like a slot machine. Have you ever seen anyone pull once and walk away?

So let’s play out a couple of possible scenarios.

You could bet on the lottery stock and lose. You told yourself you would just walk away. But that doesn’t happen. Prospect theory tells us that “a person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.” So after experiencing a loss, we are more likely to take on another large risk in order to recover that loss. Many of us know a person who has gone on tilt, emptying their bank account in a disastrous casino adventure. Some of us have even been that person. This phenomenon explains it.

On the other hand, you could bet on that lottery stock and win. In this case, overconfidence bias takes over. You’re more inclined to take on that risk again. You might begin to think that the lottery stock game is easy, or that you have some sort of system or specific insight that works. The technical term for this is 'dumb luck', and while I’ll certainly take it, I wouldn’t bet that it will continue in the future. Over time you are likely to give back all of your winnings.

Another possible outcome is that the stock does nothing. It might vacillate between 5 and 15 cents for years. It might occasionally pop to 30 or 40 cents—and you won’t sell, of course, because you think it could be the start of a huge move… until it drops back down to 10 cents. As the lottery stock languishes, you grow bored of the story, and years later just sell the damn thing to get it out of your portfolio. If you’re lucky, you’ll break even on it. It wasn’t worth the opportunity cost of the money invested in it, or the time and mental bandwidth you wasted on it.

I get it, I've lived it

And what makes me an expert on lottery stocks? I’ve done everything I’ve just described. Been there, done that. Experienced the overconfidence, the disappointment, and the boredom. Over the years the only people I’ve seen reliably get rich off of these stocks are the ones issuing shares to themselves and selling them to people like you and me. It’s a shady group of characters you wouldn’t trust to return your pen after you lent it to them, let alone manage a company you own a piece of.

Once again, our behavioral foibles work against our best interests. If you’re trying to eat healthy, don’t fool yourself into thinking you can have just one or two potato chips. And if you’re trying to invest intelligently, do your best to resist the call of the lottery stock.

 

Geoff Saab is the author of Low Risk Rules: A Wealth Preservation Manifesto, and writes a free newsletter at lowriskrules.substack.com.

 

6 Comments
Steve
August 25, 2024

I don't gamble I tell my wife, but I play the penny dreadfuls. The only difference, penny shares take longer for you to loose your money when a horse race is over in minutes. Very good article and so true, thanks Geoff for sharing.

Disgruntled
August 25, 2024

I dabble in the speckies, but I only limit myself to an amount I can afford to lose if it goes belly up.

I work and have dividend paying shares to support me.

I've done well in the speckie end of the ASX pool, got some horribly wrong too.

I have a few in play now, 2 I'm liking for returns in the next 12 months, maybe sooner. The 3rd, I'm not so sure, maybe entered too early.

Chris
August 24, 2024

#metoo..what annoys me is when these things crash the directors advocate for a buy out in some cases and cash in on all their allocated shares they got for nothing!!! Getting sick of "schemes of arrangements" !!!Yeah right...

Kevin
August 23, 2024

Yes,during the 1990s I was told by a stockbroker that all the penny dreadfuls for oil and mining raised capital non stop.Perhaps it was Ian Huntley on a state exchange lecture .The only people making money were the directors with the bowl out.Paid a good wage to keep saying the next hole is the big one,we are
so close,one more raising and the lottery ticket
comes up.

In moments of madness I think back.$1,000 dollars into Fortescue.Sanity prevails,if I picked 100 of them it would cost $100,000,and Fortescue would probably have been the 101st pick so I would still miss it.I sometimes think the same today,it's only $1,000,or $10,000 for 10 of them.I don't buy lottery tickets,the odds against are too great. Sanity prevails,do I waste $10K on lottery tickets,or $10K on penny dreadfuls,the odds are probably the same.

Geoff D
August 22, 2024

I could well have been the author of that book! I suspect there are many many others as well.

Peter
August 22, 2024

You nailed it Geoff, I think you have actually been looking over my shoulder lol! But, it does give you a good interest to watch.

 

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