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6 Ways to Protect Against Investment Hype

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investingEver notice how often the "next big thing" turns into nothing more than a big disappointment?

Investors are at their most vulnerable when they buy into hype. It can be a particular hot stock like Enron or Groupon, or a trendy sector like the 1990s' dot-com stocks that captures Wall Street's imagination. In either case the financial market pattern is familiar. A catchy story accompanied by a decent run of stock market performance attracts attention, and eager investors start bidding the price up. That success attracts more investors and leads to higher price gains.

Meanwhile, the Wall Street hype machine shifts into top gear. Media pundits on investment shows don't attract viewers by urging caution and common sense; instead, they try to outdo each other with explanations of why the latest investment craze could reach ever greater heights. Too often, the hype reaches a point where the company can't possibly live up to expectations. Also, at their peak popularity the prices of these stocks reach levels where the company would have to achieve unprecedented success for earnings to ever support what investors are paying.

Then comes a disappointing earnings report. It might be dismissed as a temporary blip, but then the next quarter's earnings fall short of expectations as well. Stories start to come out about trouble within the organization -- perhaps there's a high-profile departure, or a round of layoffs or word of production glitches. The stock starts to slide, and as more and more investors abandon ship, the decline accelerates.

In the end, as investors count their losses, the hype seems almost surreal. How could anybody have believed it all? Still, it won't be long before there's a new craze and many of those same investors repeat the cycle again.

You can save yourself some painful investment experiences if you learn to shield yourself from investment hype. Here are six ways to protect yourself:

1. Consider the investment hype source

Whether via television, podcasts or e-mail campaigns, people who are actively promoting a stock often have a financial stake in that stock. Small cap stocks, which trade so thinly that generating a little extra attention can result in big price movements, are especially vulnerable to being manipulated by hype.

Larger stocks are not immune either. Companies with charismatic leaders, like Tesla with Elon Musk, are often buoyed by the optimistic predictions of those leaders. In such cases, it's especially important to pay attention to how well operational performance is tracking those predictions, and to assess the credibility of subsequent predictions accordingly.

2. Separate stock price gains from operational performance

Speaking of operational performance, this is the true measure of success. People tend to associate stock price gains with success, but operational performance -- the ability to consistently deliver sales and produce profits in the company's core business -- is the benchmark of sustainable success.

Consider the example of Groupon. The daily deals company was such a hot property back in 2010 that it turned down a $6 billion buyout offer from Google in favor of launching an IPO the following year. Investors were so eager to get their hands on this trendy stock that upon the IPO's launch the price soared above $25 a share.

Soon after though, reports started to emerge showing that many vendors who used Groupon to promote their products were not renewing their contracts. It seems the types of daily deals that were good enough to generate buzz were a better deal for buyers than for sellers. The stock price soon started to collapse. Today, the company trades for under $4 a share, has negative earnings and is laying off employees.

3. Use stock valuation as a reference point for investment

Even companies with genuine operational success can become overpriced, which is why stock valuations are an important tool for smart investing. Using stock valuation methods like price-to-sales and price-to-earnings ratios can help you spot situations where the price of a stock has become completely unhinged from the financials of the underlying business. In such cases, you might find that it would take an impossible increase in sales and earnings to ever support the current price of the stock.

4. Set sell parameters for smart investing

When you buy a stock, you should also plan for the conditions under which you would sell the stock. For example, setting a price target that would represent success can help you have the discipline to sell when the stock has fulfilled your expectations. Otherwise, investors have a tendency to become enthralled by watching a stock's price rise, and they fail to sell while the news is still good.

Sell parameters don't necessarily have to be price targets. You should also have operational benchmarks you expect the company to achieve -- the ability to deliver on rising production targets, sales growth and progress toward profitability. Otherwise, you could wait forever for the company to reach your price targets, but if the business isn't working there is no good reason for the price to go up.

5. Focus on profitability to avoid emotional investing

Profitability may seem like a pretty basic ingredient for a successful business, but investment hype can get people focused more on a good story than the ability to turn a profit. Take the dot-com boom. Hundreds of new companies all rode the internet wave. While the internet did turn out to change modern life and commerce, the number of true long-term beneficiaries was relatively small. Most companies simply thought it was enough to put a ".com" after their name and sell shares burned through the money raised by their IPOs, never got seriously on track toward profitability and went bust once the bubble burst.

6. Understand how the company makes money

Another classic example of investment hype was Enron. In the late 1990s, it was being hailed as a new-economy innovator that had redefined the paradigm for energy firms. Investors were dazzled by its rising profits, and the company's stock market valuation rose to around $70 billion.

Even as Enron appeared to succeed, some veteran investment analysts struggled to understand exactly how the company made so much money. It turned out there was a good reason Enron's formula for success was a mystery -- much of it was due to accounting tricks rather than fundamental business success. The lesson here is that if you don't understand a business, steer clear of it. The more mysterious the business model, the more likely it could be based on a shaky premise.

All investors should strive to balance risk and return. In additional to equities and bonds, there is likely a place for certificates of deposit, money market accounts and savings accounts in most asset allocation plans. Everyone loves a winner, and it makes people feel savvy if they are in on the latest investment trend. However, really smart investing involves tuning out investment hype so you can focus on companies that are good long-term businesses.

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