Why searching for hot stocks is not always a good idea

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They’d ask you to check out stocks experts claim are “today’s hottest.” Analysts will come in and upgrade stock ratings, thereby causing a surge in stock prices. Your circle of friends also give you a nod.

Doesn’t it sound familiar? When you go shopping, it’s the same thing. Advertisements say ‘clearance sale’ or ‘70% off until today only!’ A salesperson approaches and tells you how good the dress or bag looks on you. Another person asks if you’ll want a new appliance on promotion. Your friends say it’s a great deal.

Naturally, you tell yourself: “With everyone headed this direction, I just can’t go wrong!” But can you not really?

We’re not saying it’s a bad idea to buy items at discounted prices. In fact, the value investing strategy is about looking at marked down prices. It highlights, however, that items must have a good value and a low price.

We’re saying it’s not always a good idea to just chase the hot stocks. After all, impulsive decisions often do not end well, do they?

Remember that you are using your money to buy these "hot" stocks. Would you rather just spend because people tell you to?

Why you should NOT chase hot stocks

Chasing for the hot stocks on Wall Street or the Singapore Exchange (or whatever exchange you’re interested in) may not exactly be a good idea, and seldom ends well for the following reasons:

1. Overvaluation

Typical "hot stocks to buy" have so many people jumping that it may very well be overvalued. The market overheats the prices due to over-optimism. What follows next may be a reversion of stock prices, causing investors to be burnt.

Blindly following the trend and just jumping on board the hype train rarely end well. More often than not, the jumper ends up clinging on for dear life.

This is why we recommend hunting for undervalued stocks instead of underpriced stocks based on their excellent business model, management, and track record.

2. Lack of business ownership

Most people who follow the bandwagon are lured by the trends and the promise of quick gains. And we understand that (who doesn’t want to get rich quickly anyway?).

However, as have been proven time and time again by the world’s best stock investors, the best way to profit from a stock’s growth is to understand that you are owning a piece of business you are willing to stay vested in. With a short-term drop in stock prices, most people who buy “hot stocks” tend to get spooked and cash out paper losses to real losses.

See also: Top 3 Things Investors Look for in a Company

3. Lack of fundamentals

Some “hot stocks” may very well be great companies that people don’t tend to stay vested in. Some are not so good. Must we remind the never-ending cycle of media hype -- investors jumping in -- before reality sets in?

We’ve seen it happen over and over again. We had Tulip Mania in the 1900s, the dot-com bubble, then the cryptocurrency crash early this year.

Understanding the good fundamentals of any investment is critical, side by side an understanding of the investment’s value based on fundamentals.

It’s actually simple: If you are paying too much for something that is technically worthless, would that be a good decision?

How to approach hot stocks

The general advice is to evaluate hot stocks if they’re worth buying. To iterate, searching for hot stocks has its pros and cons. But underlying these is the need to be more critical when buying. Doing your due diligence is a prerequisite in investing, be it in hot stocks or otherwise.

Below are our tips on how you should approach hot stocks.

First, keep calm and assess.

The latest IPO or hot stock does not necessarily mean it’s a fundamentally good business to place your money in. Assess the company from the ground up. You know what determinants and numbers to check, we assume. If not, head on to our free online masterclasses to learn more.

Second, do valuation.

Never overpay for any investment. Hot stocks tend to be overvalued. Figure out the right price you are willing to pay before jumping in.

Lastly, understand short-term price movements.

Short-term price movements are inconsequential to the real investor. Don’t get spooked by these fluctuations which are largely driven by market sentiment, sometimes it takes time to hold a good investment before profits are realised.

See also: How to invest in stocks AND make money

It’s okay to search for “hot stocks to buy today.” What’s not okay is impulsively buying these stocks just because somebody tells you to. Remember to do your assessment. More importantly, remember that it’s your profit at stake.

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