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Why you should think twice before buying 'hot' stocks

The difference between investors and speculators has never been more important. Make sure you’re on the right side.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

In recent weeks we’ve seen a speculative explosion in the price of some stocks and shares, often fuelled by social media networks. We think investors should avoid getting involved.

Speculators are not investors – and this is why

Never confuse a speculator and an investor.

An investor gives their money to a business – either directly through buying shares or indirectly through a fund – in the hope the company will use it to grow and generate a profit. That profit can be paid back as a dividend or reinvested in the business to fund future growth.

Either way, an investor expects to have their money tied up in the business for some time. They invest in businesses they think have a good chance of making a healthy profit from the money they invest.

Investors are crucial to the functioning of the economy – without them factories wouldn’t get built and new products would never be launched. Almost every product and service you use, from a smartphone to a takeaway coffee, is thanks to an investor backing a business to launch a product and make a profit.

By comparison, a speculator doesn’t really care what they buy. All they hope is that it’ll be worth more tomorrow than it is today. Their money rarely produces positive social outcomes and their time horizon is very short.

You can speculate in oil, in bitcoin, in currency or in shares. But as a speculator you’re only interested in the price today and the price tomorrow – what the oil is actually used for or what the company actually does doesn’t matter to you.

The risks in being a speculator

Being a speculator is risky. The main problem you face is knowing which way a price will move.

Global commodities traders spend millions of pounds on cutting edge data to try and understand how commodity prices might move on a day-to-day basis, yet no-one saw the global oil price crash coming last year. The former Chairman of the Federal Reserve Alan Greenspan described efforts by currency traders to profit from changes in currency values as little better than flipping a coin.

Even in these “well understood” global markets, the professionals struggle to say with any certainty which way prices will move on a given day. It’s even harder for the average investor. Knowing which way prices will move is the same as guessing whether red or black will come up on a roulette wheel. There are just too many variables at work.

If you buy an asset in the hope you can sell it for a higher price tomorrow you are gambling. Provided you understand this, you might feel there’s nothing wrong with it, so long as you’re betting money you can afford to lose. But don’t mistake it for an investment – it isn’t.

By comparison, an investor expects to put their money away for years. What the price is tomorrow doesn’t matter to them, since they don’t expect to cash their money out. Over the long run the risks in speculation are smoothed out.

I don’t know if a coin will be heads or tails on the next flip, and if I bet on any outcome, I have a 50% chance of losing my money. But over the long term I know it will be heads about 50% of the time and tails about 50% of the time. Investing takes this kind of long-term view.

Thinking long term and keeping your investments well diversified across a range of sectors, geographies and investment types will also help reduce risk.

When speculation meets ‘Rocket Stocks’

Speculation in shares can be doubly damaging because as more people buy a stock the price of the share rises. This proves the speculator “right” and attracts more speculators. The price gets higher and higher creating what is called a bubble.

If someone tries to sell their shares and there are no ready buyers, then the price will fall until a buyer can be found. If there are no speculators left the shares can fall a long way before an investor with a long-term view is interested. The speculative bubble is over – and the fall is long and painful. In the dotcom bubble even blue-chip tech stocks like Cisco, Intel and Oracle lost 80% of their value when the bubble burst.

The big losers in this scenario are the last investors to buy the stock who bought at the highest price. These are usually members of the public who were sucked in by the promise of quick riches and the fear of missing out.

Social media – throwing petrol on the speculative fire

You’ll notice that the key ingredient for a speculative bubble is that more and more people have to get involved. The internet, and social media in particular, makes this key ingredient a lot easier to find.

Bubbles happened in the pre-internet age – but they depended on word of mouth.

Today a few influential social media posters are able to reach millions of people almost instantly. The bubble can be quickly filled with jet fuel. That’s great news for those who owned the stock to begin with – probably including those anonymous internet posters who said it was a good idea to buy in the first place. Their shares are worth multiples of what they once were, and they can sell them. But those who buy the stock later risk being caught out when the bubble bursts.

How to be an investor

There’s nothing wrong with getting investment ideas from friends, the internet and even social media. After all, great companies often start small and you’re unlikely to find them on the front page of a national newspaper.

However, as an investor you should be asking yourself questions like: is this company a good long-term home for my money? Is the business strong enough that I’d be happy to hold it for years if the share price fell tomorrow? Do I think it’ll grow its profits in the future? Does the share price reflect that growth potential?

If the answer to these sorts of questions is no, an investor should be moving on to the next interesting opportunity – regardless of what the share price might do tomorrow.

This article isn’t personal advice. If you’re not sure if an investment is right for you then seek advice.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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