Yesterday morning, I wrote a fairly controversial article where I described individual stock investing as akin to gambling for the average investor.
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The impetus for that article was Jim Cramer’s appearances on CNN just before the Bear Stearns collapse, shouting loudly that Bear Stearns was in great shape. Check it out if you want to get a taste of Cramer’s demeanor and “advice” that turned out to be almost the complete opposite of reality:
Here’s the scoop in a nutshell for those of you who don’t follow such things. Jim Cramer is probably the most vocal and best known advocate of individual stock investing in the United States. Following a very successful stint as a hedge fund manager, Cramer began hosting what became the top-rated show on CNBC, entitled Mad Money, where he basically acts hyperactive, yelling and running around the set voicing his opinions on various individual stocks.
On March 11, 2008, Cramer loudly said on his show that the large investment bank Bear Stearns was in fine shape and that no one should pull their money out of the stock. Within a week, Bear Stearns was being bought out by J.P. Morgan and the stock value had dropped 90%.
When this all unfolded, my reaction was that this was evidence that individual stock picking was basically gambling. If Cramer didn’t know what was coming due to a lack of information, how would anyone else? Even more so, Cramer was adding bad information to the pool – people strictly taking Cramer’s advice would have completely tanked. As I said yesterday morning, individual stock picking is all about information and knowing how to find the right pieces to look at, and if someone who is supposedly a true authority at stock picking couldn’t see something that huge and devastating coming down the pike, an average individual investor has no chance at all.
After some more thinking, I turned the whole situation around again: what if the problem is Cramer himself?
The Cramer Effect
In stock trading, the “Cramer Effect” (or Cramer Bounce) is the positive bounce that most stocks get as soon as they’re mentioned on Cramer’s television show. Because Cramer has such a large audience, there are a lot of people who simply go out and buy a stock based on his recommendation.
However, when I look at the “Cramer Effect,” I think of it more widely. To me, Cramer’s real important effect is that he has built up a substantial interest among a casual crowd in individual stock investing. His show is exciting, loud, and colorful, and thus has attracted an audience that might have otherwise been watching SportsCenter or something like that. Instead, they’re watching Cramer, learning about individual stock investing, hearing about specific instances of incredible returns, and then getting involved themselves.
Is this a financially healthy thing for those people? I think it depends on what they take out of Cramer’s message. Let’s look at both sides of the coin.
Why The Cramer Effect Is Bad
On Mad Money, Cramer has a segment called the Lightning Round, where viewers call in, name a stock, and Cramer gives a buy, hold, or sell recommendation within a second. He does this by simply drawing a very fast conclusion about the sector that stock is in and whether that stock is the best stock in the sector. It’s not based on any sort of thorough research, yet people buy and sell in the real world based on what he says. That’s pretty scary – because someone on television mentions buying or selling a stock based on one second of off the cuff thought, people change their financial position.
The most obvious indication that this phenomenon really does exist is that “Cramer Bounce” I mentioned above – it’s observable and real. A lot of people out there are buying based on what Cramer recommends on his show, and as I said above, that’s pretty scary. Even worse, it teaches really, really poor investment discipline – someone on TV thinks about a stock for one second, makes an off-the-cuff guess, and you’re changing your investment approach? That’s not sound investing at all.
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The Beauty Is In The Details
Yet I’m not quite ready to toss Cramer into the trash can. If you actually take the time to sit back and read his books – particularly Real Money, which is by far his best one – you’ll find that the message he talks about is about as far from the Lightning Round as can possibly be.
The big message that you get out of actually reading Real Money is homework, homework, homework. He flat-out says you should not own a stock if you’re not willing to do an hour a week of research on that stock: reading annual reports, listening to conference calls, watching what stock moves the insiders do, reading the news, and so on.
That’s something I can agree with and stand by. You should not own an individual stock unless you have a specific and compelling reason to own that stock. Furthermore, you need to invest the time to make sure your specific and compelling reason hasn’t gone away, which would mean it’s time to sell the stock. If you can’t invest that time, then you might as well go toss your cash on the roulette wheel.
Why Irrational Is “Cool”
So why isn’t that sensible message talked about on television? It is, on occasion – Cramer talks regularly about doing the homework. But that’s not the part of his show that seems exciting. It’s when he shouts, does something crazy, screams “Boo yah!” and such that grabs the attention, and that’s the stuff that’s directly associated with stock picks.
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Just a few weeks ago, I talked in detail about Dan Ariely’s book Predictably Irrational, which focuses in on why people make irrational decisions – like, for example, basing your investment strategy on an off-the-cuff remark from a television personality.
Ariely reveals two reasons why Cramer’s seeming irrationality is followed by many people. First is the idea of relativity – they feel a need to be on the cutting edge of stock investing ideas. This is similar to why we feel some sense of jealousy and drive when our neighbors have a nice new car. This is largely the reason why people would watch CNBC and read specific stock investing advice. They feel a need to have “insider knowledge” as relative to others in their cohort – in other words, other individual stock investors, thus they follow stock tips.
The second idea is that of passion. Cramer brings more passion, energy, fire, and drive to the table than about anything else on television. It oozes out of the man – he plainly loves stock investing and that love comes out quite clearly on his show. It rubs off, and that’s how he’s attracted an audience – people like to see others with passion and they tend to believe others that show passion (think of televangelists, for instance).
Combine these two factors, plus the fact that his show has a very action-oriented sensibility, and it’s fairly easy to see why people would follow the quick pick advice and not necessarily follow the “do an hour of research per stock per week” advice.
Some Final Thoughts
Cramer’s got some good things to say if you know where to look and where to listen. The problem is that this isn’t the stuff that excites people and gets high ratings – the stuff he says that’s valuable is the boring stuff. Thus, it’s very easy to just see Cramer’s advice for the excitement, where he runs around on stage like a maniac yelling “BUY BEAR STEARNS!” even though he’s not done the research.
If you really want to get into individual stock investing, read Cramer’s books and do a lot of homework. Don’t jump on an individual stock pick just because you heard about it somewhere – do it for a compelling reason and keep your eye on it carefully to make sure that reason still exists.
And listen to Cramer, too. Listen to the part where he gives advice on how to do the homework, not the part where he yells, tosses a chair, hits a buzzer, and screams “BOO YAH!” That won’t get you very far down the road of financial success.
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