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Don't get burned by hot stocks

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POSTED: July 10, 2008 5:00 a.m.

Summer is officially here, which means, among other things, that you should apply sunscreen when you go out in the hot sun. But no matter what the season, you’ll also need to protect yourself from another potential source of burns -"hot" stocks.

Stocks that seem poised to "take off" will always capture investors’ imaginations. But the lure of these stocks may be particularly strong during, or following, periods of market volatility, when investors are looking for potential bright spots.

However, it’s usually not such a good idea to chase "hot" stocks - and here’s why:

You may be relying on an unreliable source. You can get a "hot stock tip" from anyone: your barber or your brother-in-law, your cousin or your chiropractor, your dentist or your dry cleaner. While all these people probably mean well, they may not be the market experts on whom you wish to rely. But even the so-called market "gurus" who tout stocks in magazines, on television or on the Internet may not be the best forecasters, either, so you’ll need to take their advice with a grain of salt, especially as they know nothing about your individual situation.

You may be too late. You may actually find a hot stock - but by the time you do, it’s also been "discovered" by a lot of other investors. This usually means one of two things: The stock has already peaked and is now starting to cool off or the huge interest in the stock is driving up its price to an unsustainable level, given the stock’s earnings and other factors.

You’ll be "buying high." Here’s the classic rule of investing: Buy low and sell high. It’s very good advice, except that it’s almost impossible to follow - after all, no one can really predict when a particular stock has reached either its high or low points. However, that doesn’t mean you shouldn’t at least try to pursue stocks whose current prices are low and thus may be good buys. But if you’re purchasing a hot stock - one that, almost by definition, has risen sharply - you’ve probably already disqualified yourself from the "buy low" part of the formula, which means your stock may have less "upside" potential than other, cheaper stocks.

You may be buying a stock that doesn’t meet your needs. Some stocks - whether they’re hot, cold or in-between - are simply not right for your individual needs. For example, if you’ve built a diversified portfolio, and you already have the right amount of "growth" stocks, you might be throwing your holdings out of balance - and increasing your risk level to a point beyond your comfort zone - by purchasing another growth stock, no matter how hot it seems. (Keep in mind, though, that while diversification is important, it cannot, by itself, guarantee a profit or protect against a loss.)

Ultimately, instead of chasing after hot stocks, evaluate each stock on its own merits and prospects and on how it fits into your existing holdings. A qualified financial advisor can assist you in selecting those stocks that can help you achieve your objectives. By doing your research, and by getting the help you need, you may not always nab the hottest stocks- but you’ll be less likely to be scorched.

 

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