Learn from the pain of others.
I'll come clean -- there are so many dumb reasons to buy a share that it is impossible to narrow it down to only five reasons that don't make sense.
What I'm going to discuss here are reasons that, at first glance, appear quite plausible. It's only after you've actually put them into practice that you realise they were dumb.
Having said that, I think it would be hard for anyone to beat the dumbest thing I've ever done; invest money on the strength of a tip from a complete stranger I met on the underground back in the days of dot-coms.
1. It's on a low P/E
How many times do you see the fact that a share is on a low P/E as a reason for buying it? A 'historic' P/E takes the current share price and compares it to the most recent profits. So a price of £4.50 and earnings per share of 45p (one year's earnings divided by the number of shares in issue) gives a P/E of 10.
Generally people compare a share's P/E to others in its sector, although anything below 10 is generally considered low.
However, if a share does have a low P/E, you need to conduct more research to find out the reason why. For example, it may well be that people don't believe its earnings can be sustained.
Looking at a prospective or 'forward' P/E, which compares the current share price to expected earnings for the next year, is better. However, forecasts are not always reliable. In short, the P/E ratio shouldn't be the only metric you use when trying to decide what to invest in.
2. It's paying a huge dividend
The prospect of an inflation-beating return is all very well, but some of the most attractive dividend yields tend to disappoint. A high prospective yield can be due to the share price having dropped through the floor due to poor profits and the business in question may be about to announce a cut or suspension in its dividend. Any dividend yield over 10% should definitely ring alarm bells.
As with the P/E ratio, a dividend yield is only one small part of the puzzle. You really need to dig deeper before parting with your money. I tend to look for dividends that are covered at least twice by earnings.
3. It's been tipped in the press
As a journalist myself, I know that there are very few of us who I'd be happy taking investment advice from. Most of the reports in the press seem to use broker notes as their source material, and we all know how variable their quality can be.
You can check a writer's previous tips to see how they done in the past. But it's worth appreciating that there are tight schedules on most papers and magazines and these often preclude examining a share in any depth.
4. The experts say the worst is behind us
'Experts' -- don't you just love that word. It encourages you to suspend all your normal critical faculties and just accept what they are saying at face value. Well, precious few experts predicted the events of the past two years and even fewer understood the causes.
If you're not smart enough to become your own expert, you're probably better off sticking your money in a tracker fund. If you want to learn from someone, learn from one of the greats who has actually made a fortune investing.
5. It's risen consistently
It's hard not to throw money at a market that is consistently rising. However, you should look at the economy and take a view from your own experience. For example, after six months of rising share prices, it seems the recent rally is running into the insurmountable obstacle that is economic reality.
Even more importantly, you need to focus your attention on the business you wish to buy into, as a good value share will eventually come to the fore regardless of the economic situation.
Many who bought overpriced shares when the markets were at their peak, scared they would miss the boat, are now desperate to bail out as their stocks have drifted into treacherous waters.
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