Have you ever had the feeling that you're completely alone in your thinking and the world seems to have great arguments why you're completely wrong? I felt that way during the dot-com bubble when the valuations just seemed crazy to me. I felt that way during the real-estate bubble when people would ask me if they should cash advance their credit cards to buy rental real estate. And now I feel that way in the social-media space as mergers, acquisitions, and valuations that stagger the mind. It's crazy.
Then again, maybe you're one of the people addicted to the game "Candy Crush" who can't bear to go to sleep at night because of its addictive tendencies. I know people who turn off the lights at night with a little glow under the covers as they attempt to navigate this popular game.
King Digital Entertainment, which markets the game, reports huge increases in downloads and has decided to capitalize on the game's popularity by going public.
Hey, doesn't this sound a lot like Zynga with their hugely popular game Farmville? That really didn't work out too well as an investment for most investors. How is King Media different? Eighty percent of the company's revenue comes from this one game so this better be the next "Wheel of Fortune"-type franchise or investors will face a bad outcome.
Can gamers get bored and move along to the next fad? Yup. Just check out this chart.
When investing in new technology, it's a buyer-beware environment where you are speculating on future market share and the ability to monetize eyeballs into dollars. Facebook's WhatsApp purchase is a clear $18 billion example of a company willing to spend massive dollars in order to add a feature to keep users loyal to Facebook. While the company states the two enterprises will be operated as separate companies, you can be assured that Facebook has grander plans to make WhatsApp a reason for the fickle teens to stay with Facebook. After all, you know what happened at MySpace; fortunes can change very quickly.
Look at Groupon on as a perfect example of a company that had great market penetration but is still struggles in terms of profitability and strategic vision. The company came out at $20 a share 2 years ago and is now trading about 8 dollars a share. Of course, last week's headline was a Groupon shares soared. If you've gone down 75 percent and then go up a dollar, I suppose you could make the case that the stock soaring. It's all a relative game and frankly a pretty weak case.
The boring folks at Apple are criticized for not engaging in a bidding war for companies. They seem to be pretty conservative when it comes to spending shareholder money as evidenced by the $170 billion dollars they currently hold on their balance sheet. Sure they buy little companies but they tend to be tech plug-ins rather than transformative, gigantic purchases.
Google bought Motorola and it's debatable whether that was a wise $12 billion purchase given that they just sold a handset business for a fraction of what the original purchase price was ($2.5 billion). Then again, Google gets to keep the patents portfolio and perhaps that's worth the acquisition price to help defeat patent trolls. Maybe -- but I doubt it.
Reportedly, Google offered $9 billion for WhatsApp and dropped out after Facebook paid twice that amount. Hooray for Google's fiscal rationality! Maybe the Motorola purchase still burned in their fiscal psyche.
I get that social media is going to be huge and already is a major driver of Internet traffic. What I don't get is the valuations assigned to these companies.
Let's look at another example: Twitter hasn't really figured out how they're going to make money to justify their current stock price. They might figure it out down the road but might doesn't mean they will. Real world investors need to be aware that buying companies like Twitter are essentially a speculation on their ability to position the marketplace in a profitable way. It all comes down to that.
I know what you're thinking; every day venture-capital companies jockey to throw millions of dollars at start-up companies. Certainly, if VC partnerships are investing in Internet star-ups, it must be wise for you to do the same, right?
Think twice before you automatically agree.
Remember that VC companies are seeking to hit one gigantic home run for every 9 or 10 investment whiffs. Sequoia, which invested $60 million in WhatsApp is hitting a massive home run; they are reported to be getting a $3 billion dollar payout. Not bad, huh? That will make up for all the other investments that didn't work out so great that you never hear about. It's all about batting average in the VC game and, if you've got the free capital, perhaps it's worth the risk to try a 1 out of 10 lottery ticket.
But for many of you reading this commentary, you need better odds. You can't afford to lose 9 times because losing 9 times for you means your lifestyle is impacted. And for that reason, you need to be very cautious about throwing money at a company that has not defined how they are going to justify their current valuation.
You might get lucky and pick the right one. You might be wise enough to pick the right one. But the real question is, are you solvent enough to survive 9 mistakes, for most investors the answer is" no."
So, if you're going to invest in this type of asset do so sparingly. And just like when you're in Las Vegas, do so with money you can afford to lose. Invest in these assets in non-retirement accounts so if a blowup does occur, you are able to write off the loss. And make sure that you have a strong foundational portfolio that will help you survive the inevitable unforeseen volatility that will no doubt occur as the market goes through its now normal gyrations.
The average P/E ratio of the S&P 500 is about 16. If you see a stock with a P/E ratio of 40 or greater (or no P/E ratio because they have no earnings!), be self-reflective and ask yourself if you can handle the risk and the potential loss. I know you can handle gain, that's not the issue. Just like in gambling, only bet what you can afford to lose in high valuation stocks. That's how you keep your net worth intact. That's how you avoid the fate of millions of lottery chasers that bought dot-com stocks in 1999; rental real estate in 2007; railroad land in 1860, and tulip bulbs in 1637.
History does tend to repeat itself. John Templeton was right: The most dangerous words in investing are "this time it's different." Buy with your eyes open and a recognition of the risk you are taking on when you buy high valuation companies. Then you won't be surprised when you hit a home run or must tend to the wounds that come with making the wrong investment choices.
This story originally appeared on CNBC