4 stock buys to avoid
February 01, 2013
With today's low savings and money market rates, it's natural to look toward the stock market for higher yields. But while that may be a rational decision, it's important to tread carefully to avoid making some regrettable picks.
Stocks, of course, are much riskier than guaranteed bank deposits. At this point though, with dividend yields on the S&P 500 at more than twice the level of the best bank rates, stocks have offered a better source of income lately, and with their growth potential they at least offer a chance at beating inflation.
But with that growth potential comes the flip side: the risk of loss. To reduce your risk of losing money when you pick stocks, avoid making these four types of stock buys.
1. Story stocks
These are companies that have an interesting twist to their business model or some compelling anecdote that makes for a colorful tale. They are often the stocks that are hyped on TV stock-tip shows, but with that hype usually comes an inflated price.
Even if the story is legitimate, it is difficult to get ahead when you are investing in a story that is already well known. For example, financial writer Jack Schwager did a four-year study of stocks plugged by Jim Cramer on "Mad Money." While those stocks got an immediate boost from the mention on the day of the show, over the longer term their performance lagged.
2. Last year's top performer
Momentum can be a powerful thing, but eventually it runs out of steam. Buying hot performers means you are paying top dollar for your stocks, and if anything goes wrong those stocks have a long way to fall.
3. The "next Apple"
When a company has a breakthrough success, some investors immediately start looking for a similar company that can follow in its footsteps. The problem is, in many markets the last thing you want is a company that's trying to imitate the market leader -- that leader's resources and reputation are likely to make things difficult for the next competitor to come along.
4. Franchise stocks
There have been a series of these over the years, often restaurants. They are concepts designed to be repeated all over the country, and soon their stores start popping up everywhere. These can be dangerous stock buys for two reasons.
One reason is that when a business is expanding rapidly, you have to take growth figures with a grain of salt. Opening a large number of new stores is likely to produce some strong revenue growth, but the real questions to ask are whether those stores are profitable, and whether existing stores can continue to grow once they are established. The second reason to be wary of franchise stocks is that if they are being funded by selling off franchise rights, you have to be careful of the pyramid-scheme effect. Will the whole thing collapse once there are no longer enough new people willing to buy the franchises?
The nature of stocks is that they represent long-term investment commitments. If you are buying on the hopes of getting rich in the next few months, you need to re-evaluate your reasons for getting into stocks in the first place.