I receive quite a high volume of emails about stock picking, i.e. choosing the right company shares to invest in. This article will point out some bad practises that I have seen, by highlighting four ways in which you SHOULD NOT go about this exercise.
However, I recognise that some investors simply love to follow an active investing approach. The thrill of finding a ‘gem’ and staking money behind your analysis can be a rewarding experience.
How not to pick stocks & shares
1. Don’t follow TV pundits
Jim Cramer is a TV personality who appears on US news channel CNBC to talk about investing. The former hedge fund manager has a wacky and over-the-top presenting style that sees him bounce around the studio with enthusiasm (or sometimes anger)
His unstable persona and cheesy sound-effect buttons are not where you would expect to find credible investment advice. But 200,000 people actually tune in to hear Jim’s trading ideas and rambling advice every week.
Pundits like Jim have a fixed schedule of shows and need to fill them with buy and sell signals. In practice, this means Jim creates too many trade signals for an investor to follow to the letter.
I’ve also found that his statements often contradict one another. This makes it challenging to stitch together a coherent investment strategy from his advice.
Like many other pundits, Jim has been on the wrong side of history at times. For example, Cramer recommended that investors buy shares in Lehman brothers months before it collapsed in 2008.
This is where Jim’s chaotic approach becomes his trump card. In response to criticism he responded: “One week before Lehman Brothers collapsed, I told everyone to get out of stocks”.
Jim gushes so many opinions about so many topics, he can find a way to defend most of his calls, because at some point he’ll have made an accurate prediction! This won’t bring any relief to angry viewers who invested in Lehman Brothers.
I’m reminded of the saying; ‘even a broken clock is correct twice a day.’
2. Don’t follow ‘Hot penny stocks’
‘Penny stocks’ are companies which are listed on the stock exchange, but are worth – as the name suggests – pennies per share.
Penny stocks are something of a fascination among risk-seekers because of their ability to deliver huge returns.
Shares can only be priced to the nearest penny or cent on the London Stock Exchange or New York Stock Exchange respectively. This means that if a share priced at £0.02 rises to £0.03 – you’ve made a 50% return!
Because the pricing unit is so cumbersome relative to the tiny value of the company, extreme volatility is the result. If the price changes at all, you’ve either won or lost a significant chunk of your investment.
Penny stocks operate in a different universe to large listed companies. Several of the benefits I describe in the article Why are shares good investments? simply don’t apply to penny stocks.
They’re infrequently traded, the buy & sell prices will be wide apart an uncompetitive, and the underlying companies will leave much to be desired.
There is, of course, a reason why companies fall to such low valuations. And it isn’t because they’re optimistic companies with solid management teams.
Are shares a risky investment? Not very risky if you can hold them for a long period, as I demonstrate in that article. Penny stocks are the exception, they’re a gamble that I score as 10 out of 10 on the risk scale.
3. Don’t invest in companies mentioned in unsolicited mail
You may have received ‘investment reports’ through your letterbox that explain the virtues of a listed company and encourage you to buy shares.
Such leaflets are examples of ‘Pump and Dump’ investment scams. This is where criminals buy shares in a small company, then promote the stock heavily through cold calling and leafleting.
The leaflets and brochures often make simplistic connections to current events or make false claims that a household name like Warren Buffet or Bill Gates has already invested in the same company.
When buy orders push up the price temporarily, they quickly sell their holdings and pocket a profit. This leaves investors nursing serious losses when the prices fall soon as soon as the hype stops.
4. Don’t pick-up stock tips from relatives
Stock picking and friends & family can be an awkward combination. I encourage people to talk about money and investing principles, but promoting individual company shares over dinner is a dangerous game.
If you ever want to experience the very definition of ‘awkward’, lose £1,000 after a ‘sure thing’ recommendation from friend crashes and burns.
Ask yourself, given that relationships are very important, is the risk-reward trade-off worth it?