Buying hot stocks not always the best choice

“Derek, everyone at work is talking about a ‘hot stock’ — should I invest in it too?” When a stock or fund advances to record highs and becomes the centre of media attention, many investors are eager to buy in right away. It’s not always the wisest choice, however.

This week the Advocate introduces Wealth Watch, a column that addresses financial and retirement planning issues. It is written by Derek Fuchs, a wealth adviser with ScotiaMcLeod in Red Deer, and a certified financial planner, financial management adviser and fellow of the Canadian Securities Institute. Wealth Watch will appear in the Advocate’s Business Section the first and third Wednesday of each month.

“Derek, everyone at work is talking about a ‘hot stock’ — should I invest in it too?”

When a stock or fund advances to record highs and becomes the centre of media attention, many investors are eager to buy in right away. It’s not always the wisest choice, however.

Many outperforming investments have growth that ends up levelling off or declining, causing many who invested too late in the cycle to sell at a loss. In other cases, the rumour around an investment proves to be just that, rumour, and it eventually comes falling back to earth.

So before you chase down that hot stock with a fistful of dollars in your hand, take a minute and consider these points carefully.

Buy high, sell low?

When you chase performance, you’re hoping to buy high and sell higher (as opposed to the usual mantra of buy low, sell high).

But you’re taking a chance that this hot investment has more upside than another stock or fund attractively priced with solid fundamentals and growth potential.

Is this how I usually invest?

Unfortunately, the desire to make a sizable profit in the short term usually occurs without regard to how the stock or fund aligns with your investment objectives. For example, an investor with a conservative growth portfolio who starts pursuing hot funds might stray to a risk level beyond their comfort zone and inappropriate for their goals or time horizon.

Hot or not?

In some cases, hot stocks end up falling because sudden investor activity drove the price to unsustainable heights, and ultimately the underlying investment couldn’t meet the lofty expectations of investors.

An outperforming mutual fund may also fall due to increased investor activity, a condition called “asset bloat.”

An example is when a fund manager capitalized on a type of market opportunity that is limited in scope, and can no longer find enough of those opportunities when suddenly faced with massive amounts of assets to invest. In short, investors keep investing in his fund but he can no longer find the same opportunities.

The perils of market timing.

Whether it’s a stock or fund, your investment can experience a loss simply because of bad timing. You got in too late, when the security had peaked.

This can particularly be true with niche investments — such as natural resources, real estate and emerging markets — which are more volatile and can swing sharply.

A history lesson in chasing returns.

There is good reason why investment fund companies must use the disclaimer, “Past returns are not indicative of future results.”

Here are some examples of chasing performance that do not include years of broad market downturns:

l If you chased after BRIC equities that returned 64.3 per cent in 2009, the index tracking the performance of Brazil, Russia, India and China would have given you a 2010 return of 4.1 per cent.

l If you invested in Canadian small companies (small caps) after their 2006 return of 16.7 per cent, you would have had a 2.0 per cent return in 2007.

l If you bought Canadian information technology because it gained 53.5 per cent in 2009, you would have experienced a 2010 return of 4.7 per cent.

My final thoughts? By diversifying your portfolio across asset classes, geographic regions, investment styles, economic sectors and market capitalization, you increase your exposure to potential top performers while minimizing the effect of underperforming securities.

You can still add individual securities in the pursuit of higher returns, but you should always have an eye on evaluating the merits of the investment and its suitability to your portfolio — without chasing after a hot stock or fund.

Happy investing!

Derek Fuchs can be contacted at derek.fuchs@scotiamcleod.com.

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