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Stock Tips Can Lead to Bad Investments

Aug 17, 2007
When everyone you know is talking about the latest hot stock, it can be difficult to resist the urge to invest. Perhaps your neighbor doubled her money in some fancy new biomedical stock. Maybe the newspaper is touting a certain company as "the next big thing." Maybe you saw it in an investment newsletter. Regardless of where the stock tip comes from, putting your money on the line can easily have negative consequences.

Investing in stock tips is nearly always a bad idea, for a number of reasons. The first is very simple. Many hot stocks become hot because people like the idea of the company. Unfortunately, likeability and financial viability are two very different qualities. If a company doesn't operate under a sound business plan, it won't do well in the long-run, no matter how many investors put their money into the company. The technology bubble of the late 1990s is an excellent example of this fact. During that period, it became relatively easy for almost any internet-related company to acquire funding. This led to dozens of well-funded businesses with business plans that didn't actually include concrete strategies for becoming profitable. While a few sound companies pulled through, a large number of the companies that went public during that period are no longer in existence.

While it may be possible to avoid the pitfalls of accepting stock tips, there is one unavoidable truth. Unless you are acquainted with very financially active and literate individuals, your 'hot-tip' will probably arrive 'stone-cold'. Because stocks can be traded instantly, new information is reflected very quickly in the price of an asset. If you hear about a stock tip in the newspaper, investment newsletter, or from a friend, there is a very good chance that many others have heard the very same thing, and that the market price has already adjusted itself to those expectations. In fact, if the stock tip you received was acted on by enough investors, the price could become temporarily inflated, causing even bigger losses when prices readjust. Today's hot stock tip could be tomorrow's Enron.

Despite the fact that most stock tips are not worth acting on, investing in single stocks can be an enjoyable and rewarding pastime for those who can afford the risk. Because hot stocks are so difficult to choose, however, it is important to be aware of the very real and significant risks. Don't allow yourself to be seduced away from sound investing principles to act on the latest hot stock tip.
About the Author
Joel Arberman is the Managing Member of Stock Aware, LLC. We publish a free stock research and analysis newsletter. Learn more at
www.StockAware.com
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