You Must Buy this Stock, Now!

Jul 6, 2010

Think about the first time you received advice from a friend on buying a stock. Was it a stock you had heard of before? Often, these friends have hot information about an up-and-coming technology stock that’s sure to boom. Easy money! 

The sad truth is that many of these small cap growth-oriented tech stocks fail, leaving the stock value at zero. Sometimes, the product is a great idea, but uncontrollable external factors such as regulatory issues make it difficult for the company to get off the ground. Or it could be a ground-breaking “green” company with an innovative idea that simply doesn’t have the financial funding and consumer demand to become successful. 

So why do we listen to a college buddy, co-worker or personal chess coach for stock advice when they have zero investment background? Two reasons—the fear of a missed opportunity and greed. We don’t want to miss out on an opportunity of a lifetime to invest in the next big thing. Ten years from now we don’t want to hear our friends say: “I made big bucks, I can’t believe you didn’t listen to me.” Also, we are all naturally greedy. As investors, we want the big score without the big loss. Many behavioral finance experts believe it’s human nature to want little-to-no risk with a guarantee of high investment return. But in fact, we do not fear risk, only loss. We are not risk averse; simply loss averse. To the greedy ones, risk represents more opportunity for investment gain, not the increased chance of investment loss.

During my first year of graduate school at Texas Tech, I asked my Behavioral Finance professor, “How do you know what your risk tolerance is for investing?” He responded by asking me, “Well, would you rather eat better or sleep better?” What my professor meant was, for some investors taking on a lot of risk such as investing $10,000 in a small company stock gives them the opportunity to make a lot of money.  However, for other investors, the worry of potential investment loss will cause them to lose sleep.  For these investors, a less risky investment should be considered.  The truth is, until you experience a loss you won’t know what your risk tolerance is. My advice: Stay away from Uncle Leo’s stock tips. No one can afford to lose $10,000 to an unknown up-and-coming stock. At least, no one I know.

There’s no guaranteed return with any investment you make in life. This is why when it comes to equities, we recommend investing in no-load, low expense, quality managed mutual funds. These are made up of hundreds of individual stocks, lessening your risk exposure. A diversified portfolio is another great way to lower your risk exposure, stress level and get a better night’s sleep. I also recommend a nice comfortable bed!

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