This article is an excerpt from the Shortform book guide to "Naked Economics" by Charles J. Wheelan. Shortform has the world's best summaries and analyses of books you should be reading.
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Can you get rich quick from stocks? How do investors determine which stocks are going to pay off big?
The stock market has a reputation for allowing people to “get rich quick” by betting big on a stock that pays unexpectedly large returns. Unfortunately, this reputation is misleading. Although it certainly can happen occasionally—just as gambling in Las Vegas can occasionally make a person wealthy—the unremarkable truth is that get-rich-quick schemes usually fail because they hit two realities: 1) all information is public, and 2) people don’t typically undervalue their own stocks.
Here is why getting rich quick off stocks is extremely unlikely.
1. All Information Is Public
The first reason you can’t get rich quick off stocks is that all information is public and it’s unlikely that you know more than other investors about any particular stock. If you’re looking to bet on a stock that will increase in value significantly more than other stocks, you’re essentially looking for an undervalued stock that no one else has noticed—in a world filled with people constantly looking for these kinds of things. Not only are you competing with investors with decades of experience and training, but you’re also competing with supercomputers programmed to seek out pricing imbalances. The chance of you outsmarting them all is small.
The main reason you can’t outsmart other investors is that all information you can make trading decisions with is available to the public. In order to outsmart other investors, you’d have to have access to information about a company that other people don’t, such as yet-unrevealed test results for a new medicine. However, it’s illegal to trade on information that’s not available to the public, so even if you had access to such knowledge, you’d be unable to act on it.
Large, sudden price movements are driven by unanticipated occurrences, such as a company unexpectedly announcing that it missed its sales targets, or suddenly becoming the target of a criminal investigation. The paradox is that these events drive stock price changes because they’re unpredictable, which means—importantly—you can’t predict them any better than anyone else can.
2. People Don’t Typically Undervalue Their Own Stocks
Second, get-rich-quick schemes violate a fundamental principle of economics: that everyone, not just you, is looking to maximize their utility. In the same way that you want the stocks you hold to have a high value, other people also want the stocks they hold to have a high value. People don’t make money by underestimating the value of their stocks; if the stock is strong, they’ll price it accordingly. Therefore, if a company has a good chance of succeeding in its industry, its stock will typically reflect that, and you are unlikely to discover a stock priced low that is actually worth a lot.
Again, everyone in the market has access to the same data. Therefore, in general, stocks are priced to accurately reflect all the available information pertaining to them, and it isn’t possible to maintain long-term success by buying and selling undervalued and unnoticed stocks.
Basic Investing Guidelines
Here are a few guidelines you should know before making investment decisions:
- Know that high risk brings high reward: Companies that have more instability—they may become fabulously successful but may also fold—have to convince people to invest in their stock by promising higher returns. You may get rich off this stock but you may also lose your seed money. More established companies and governments offer a safer but lesser return. As an investor, you’ll have to decide which strategy you have the stomach for.
- Diversify: Your money will be much more likely to bring you a return if you invest it in a wide variety of stocks in a wide variety of industries, so that you’re less vulnerable to wild price swings in any one industry. Index funds, which invest your capital in thousands of stocks, are a great way to accomplish this, and they typically have a long-term return rate that meets or beats the average.
- Invest for the long run: Choose investments that will bring you returns decades from now. If you choose your investments wisely, remember that the laws of the market will apply to them: You’re loaning money to someone else so they can use it productively, and you should expect to earn something for that service. Over time, the stock market generally abides by this rule, and the longer you hold your investments, the likelier you are to see an overall positive return that will even out the occasional drops in value.
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