(1) they get a recommendation from a broker, family member, or friend,
(2) they have personal experience using a company’s products or services, or
(3) they see or read from media that a company has a positive development.
An investor may find a great stock by one of these methods, but there is probably a better chance the stock will be a loser.
Buying stocks based on a hot tip from a friend or family member is usually not a smart move. The source providing the information to your friend or family member may be questionable or have a hidden agenda. Moreover, the rationale given for purchase of the security is generally not thorough. The person providing the recommendation usually doesn’t follow up and give an exit strategy or tell you when you should sell.
The hotter the tip, the more speculative it is likely to be. These are stocks that you are told have a good chance of doubling or tripling in value, when, in fact, there may be a bigger probability that you could lose a half to a third of your investment. One of investment’s golden rules is in order to achieve large benchmark-beating returns you have to accept risk greater than the market. There is no free lunch. Brokers can be helpful in providing information and executing trades, but they also have a financial interest in giving you advice on specific stocks. After all, they make money from commissions when you purchase one of their recommendations through them.
The second most common way people choose stocks is through familiarity with company. You assume that if you use and like a company’s products or services, others must like them, too. The problem is that many people come to this conclusion without considering the firm’s financial condition or competitive position.
The products of a company that you think are a great value may be a tremendous deal for consumers but not produce much profit to the company. Furthermore, the particular product you like could be a big money maker but might represent only a small fraction of the company’s revenues. Even good companies with several successful products do not necessarily make good stocks. Sometimes strong companies can have stock valuations that are very expensive compared to what they can realistically expect to earn going forward.
A third main way investors choose their stocks is by the media reporting a positive news development for a company. For example, when a newscaster on television says that company X has a new potential blockbuster drug or company Y has a new revolutionary technological gadget, this will surely garner a lot of investor interest. The problem is that beside you, many other people will be simultaneously getting the same information. By the time the information is conveyed to the marketplace, there is a good chance that the stock may have moved already and not allow the investor to get a favorable price. These stocks tend to have most of the good news already reflected in the stock price. The stock market is usually very efficient in incorporating breaking news events into the price of a stock.
Reasons
The main reasons why most people rely on these three methods for choosing stocks are habit, laziness, and that they do not have the knowledge or self-confidence to do it other ways. They have always done it that way, and it requires very little effort on their part. Invariably, the stock tip from your brother-in-law or the stock-picking idea based on your own experience with a company will not take into account your tolerance for risk and your time frame. Even if it does, you should take the extra step and compare a stock with some of its peers and learn as much about the company as you can. In this day and age, tools are widely available at little or no cost that make the comparison easy. Unfortunately, a lot of people give more thought to where they want to get out to dinner on a Saturday night than they do to where they should invest their life’s savings.
Written by Michael Kaye, CFA
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