Never Buy a "Great Stock"

Never buy a “great stock.”

What, you say? Doesn’t every investor want to own great stocks? Of course they do and so do you, but the “great stocks” I’m talking about are usually the ones a well-meaning neighbor or co-worker tips you off to as the next Microsoft or whatever.

Usually these stocks fall into three categories:

• Christmas Tree Ornaments – all shiny on the outside, but hollow and easily broken at the slightest touch. They capture the attention of investors easily distracted from sound investing principles with their glitter, but ultimately fail because they are not viable businesses. In six months, no one will remember its name.
• Bicycles – what your friend doesn’t realize is that this stock is tied to an economic cycle which is about to swing in the opposite direction. She bought the stock when demand was high and the stock was fat, things are going to change soon and the tires are going flat.
• Great, but Late – your friend is right about the stock, it is great. Unfortunately, the market has bid up the price past the point where you can realistically expect to make any money. This is the “buying high” part of the equation that results in losses (buy high – sell low).

There are two parts to making a good investment decision (assuming your goal is to hold the stock in your portfolio for some period). The first part is to identify a company with a sound business and good prospects for future growth.

The second part is to identify a price that makes sense for where the company is and where it is going. You have to pay for both. The trick is to not pay too much for either.

Although there are numerous formulas to help you determine current and future value, figuring out the right price to pay for a stock remains as much art as science. In subsequent articles, I explain these formulas and how to use them. However, part of learning to invest in stocks is developing a feel for what makes sense.

Take a Pass

When you are investing hard-earned dollars, it makes sense to take your time and get comfortable with your decisions. If a stock doesn’t “feel” right, take a pass. There are many opportunities, so you don’t have to jump at the first, second, or twentieth stock you analyze.

If you pass on a friend’s “great stock,” and it turns out to be a home run, congratulate them for their good fortune, but don’t second-guess yourself. For every home run, there are 20 strikeouts.

A wise investor once said, “One of the best ways to make money in the market is to not lose it.”