So you get a “great tip” from a relative, friend, co-worker or even a broker. How do you know it is a good tip and not just one those idle rumors that seem to forever float around out in the world of trading? A short list of smart questions will help you avoid the big mistakes many traders make just because they act on tips without knowing the facts first.
1. Okay, so why is this a good trade for me? In other words, what criteria do you use to trigger a well-timed investment or trade? You might be surprised (but you should not) to discover a startling truth: Most people giving you “free tips” have absolutely no idea how to answer this question. Chances are, they are just repeating something they heard at the water cooler an hour ago.
2. How many shares do you own and how long have you had the position? The answer to this is interesting. If they own a lot of shares, are they trying to get you to buy to put pressure on the price? This technique, the “pump and dump” when done in the extreme, is based on the “greater fool” theory of investing. But what if they don’t own any shares? Why are they telling you to buy?
3. If you own shares, has the value gone up or down since you bought? If they have gone down, by how much? What was your purchase price? If they have gone up, how high do you think they will go?
4. When do you plan to sell? Do you have either a profit or a bail-out target price? Here again, the majority of trader tipsters don’t get into this esoteric stuff, they just like to give out “free” recommendations without much analysis. If the tipster doesn’t know the answer (and most don’t) then how do you know whether it is a good purchase or not? Knowing when to exit is just as important as knowing when to enter.
5. What product or service does the company sell? This seems like an obvious question, but you will be amazed to discover that many folks simply do not know the answer. Many people think they know what companies sell because the names are household words. But for example, you know that General Electric sells appliances, right? But that is only 6% of their total business. The largest segments are capital finance (33%) and energy equipment and infrastructure (26%). The company also owns NBC, which is widely known, but that’s only 10% of the operation. If you didn’t know this, you’re not alone. Many big operations are in several businesses, but traders and investors are often simply not informed.
The point is this: If you are going to invest in a buy-and-hold strategy or trade in a day or swing trading mode, it doesn’t matter. Being informed does matter and the wisest investor or trader learns quickly that acting on tips is a poor idea. Whenever someone gives you a “hot tip,” ask these questions to find out what your source really knows … or does not know, about the company itself.