Philip Elmer-Dewitt recently wrote this article that chronicled the severe financial hardships that befall those who chose to follow the advice of Andy Zaky (who runs The Bullish Cross). It's a terribly sad story that chronicles how Apple's (NASDAQ:AAPL) fall in share price from $700 per share to well under $500 crippled the financial solvency of hundreds of investors that followed Zaky's specific advice. I am not writing this article with the purpose of criticizing Zaky or engaging in some kind of schadenfreude regarding the unfortunate Apple investors, but rather, to look at the very real mistakes that were made so that we can avoid them ourselves with our own investments, be they Apple or otherwise.
Let's look at the first in a bad string of decisions.
"Following the lead of a 33-year-old investment advisor named Andy Zaky who had written that Apple was going to $750 by January and to $1,000 within a year, Smith converted most of his Apple common stock -- more than he should have -- into high-risk Apple call options. When those options expired in the third week of January with Apple trading below $500, they were worth exactly zero. Smith had lost roughly $400,000 and all his Apple shares."
The specifics of the story are self-explanatory: he bought high-risk Apple call options that didn't work out, and were "worth exactly zero." But we should discuss why they were so dangerous. Even if you find an undervalued stock, and believe either that the earnings are going to grow or that the company is running a business that should be worth a lot more, there is no ability to control when the market recognizes that fact. It's a dangerous game to play because there is nothing to stop a stock going from cheap to cheaper. Apple currently earns $44 per share. Maybe it will earn $50 per share next year. And maybe it should be worth 14x earnings, or $700 per share. But you, personally, have no power to get the market to recognize that fact. It doesn't make sense to me to make wagers in which you must force the other stock market participants to recognize the value of your holding within a specified period of time. Those are the kinds of terms that are ripe for something bad to happen because you are not putting yourself in a position to control your own destiny.
Secondly, one of the big morals of this story is the need for diversification, diversification, diversification. When I read this account of what happened, I couldn't help but think about the reasons why Benjamin Graham spent his whole life insisting upon diversification. For Graham, diversification was not all about being rich, but rather, it was about not being poor. If you ever get a chance to read Benjamin Graham: Memoirs From The Dean of Wall Street, you will learn that Graham grew up very poor, and "his moment" came when a grocery clerk refused to accept a check from his mother because her credit reputation was too unreliable and the grocer couldn't chance lending out the money.
The spirit of Graham's reaction to that moment stuck with him the rest of his life, and that is why he quietly continued to do his own thing (owning countless dozens of stocks across his portfolios) when his young protégé Warren Buffett began touting the benefits of concentrated portfolios. Look at what happened to these men that followed Zaky into Apple. Years and years of accumulated wealth relied upon Zaky's next call with Apple. If you ever reach a point where the bankruptcy of one of your holdings would create an obstacle you couldn't handle, then you're not diversified enough. You never want to allow a single stock holding to do as much damage to you (or even more) as an employer letting you go. That's an undesirable position to be in, and you're best off avoiding it all together.
Here's the most important passage from the entire article:
Zaky had taken under management more than $10.6 million of other people's money and lost it all.
But those lost millions -- suffered largely by well-to-do investors who knew the risks they were taking -- pale next to the damage done to the 700 subscribers at Bullish Cross Pro. Many of these investors have since fled the site and joined a Google group called bc-subs (for "Bullish Cross subscribers"), where they commiserate about their lost retirement funds, their ruined marriages, their thoughts of suicide. Many lost hundreds of thousands of dollars. Some lost millions.
"A significant number of the people who lost money following Zaky's trades were people who were not sophisticated enough to understand the instruments in which they were investing," says one member who asked not to be identified. "Early on, Zaky had made recommendations about not putting more than a certain percentage of one's capital into following his Apple positions, but most people ignored that."
And thirdly, out of all most dangerous things that an investor can do, investing in something that you don't understand certainly has one of the top spots on the short list. This story is incredibly sad. The lives of these gentlemen are ruined. For the most part, these are probably good hard-working men who got caught up in the moment and lost it all, or nearly lost it all. When they talk how this is ruining their marriages and leading to severe depression, it reinforces to me that this is a pain best felt vicariously. The wrong way to react is by dismissively thinking, "This could never happen to me." I bet every single one of these investors that lost it all on Apple over the past year never believed it could happen to them.
That's why it's a good idea to take a page out of David Van Knapp's book and craft some kind of investment policy manual of rules. Maybe put together your own ten commandments of investing rules you'll never break. If you put automatic provisions in place that never allow you to have, say, more than 15-20% of your wealth in one stock at a given time, you can mitigate a lot of potential for pain from the very beginning. Also, there's a certain edge you can gain by simply sticking to plain vanilla investing and just buying stocks outright when you think they're undervalued. It can be quite dangerous making bets that not only rely on you having to be right, but having to also specify when you'll be right. It's a completely unnecessary cross to carry, so don't pick it up in the first place. The folks in the Apple story above combined a lack of diversification with a lack of knowledge with unnecessary call options. The end result was a nasty chemical cocktail that blew up their life's savings.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.