Your Friend Just Gave You a Hot Stock Tip. What do you do?

A friend, colleague or relative just gave you a hot stock tip. What should you do? Should you run out and go buy this stock? No! The simple answer is, “Thanks, I’ll look into it”.

Buying a stock, bond, mutual fund, or any other investment without doing your own research is not investing it is speculating. Your goal is to maximize your returns, and minimize your risk. The only way to achieve that goal is to do your own research. This research doesn’t have to take long. Here are some basic questions that you need to answer before you buy any stock:

1.       What business is this company in?

2.       How does the company make money?

3.       Does the company have a strong long-term record of increasing earnings?

4.       Does the company have a strong long-term record of increasing dividends?

5.       Does the company have low debt?

6.       Will people still be using the company’s product or services 20 years from now?

7.       Is the company stock undervalued?

A simply step-by-step approach will ensure that you don’t make any bad investments and lose your money. If you can’t answer any of the above questions, then do not purchase the stock. Even if your friend tells you the stock is already up 128% and will “continue to skyrocket this year!” In fact buying a stock when it’s high is exactly the wrong time to buy.

Your friends mean well, and they just want to share their enthusiasm and help you earn more. But their financial situation might be different, or they might also be speculating and not investing. So always do your own homework and reach your own conclusions, and you will do very well for yourself.

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Comments

[W at Off-Road Finance]

I would take issue with your definition of speculation vs. investing (my alternate take: http://www.offroadfinance.com/2011/10/12/speculation-and-investment/ and http://www.offroadfinance.com/2011/11/07/why-im-a-speculator-rather-than-an-investor/)

By my definition I am a speculator, not an investor. That said, tips are almost always garbage. There's about 3 people in the world who I would put some weight on it if they gave me a tip. None of them are in the tip business.

[Kanwal Sarai]

Hi W at Off-Road Finance,

Thanks for your comment, I read both of the articles you mentioned and I agree with your statement:

"In other words the speculator is interested in the future behavior of others trading the same security. The investor is interested in the behavior of the security itself. If the bond market shut down tomorrow, the primary dealer would be stuck with an unwanted inventory whereas the pension fund [investor] would simply be unable to buy more bonds, but would be perfectly happy to keep the ones already purchased."

My definition of speculator and investor is actually borrowed from "The Intelligent Investor" written by Benjamin Graham in 1949. Graham devotes all of Chapter 1 to this topic, and I highly recommend it.

I guess our focus is different, my first goal is to obtain a steady stream of increasing income (thru dividends) and then take advantage of any increases in the stock price itself.

cheers,
Kanwal