In the never-ending quest to put together the perfect portfolio, finding stock recommendations isn't a problem. Just about everywhere you look, you'll hear a cacophony of Wall Street stock peddlers pitching their latest and greatest ideas. Even once you clear out the noise and find analysts you can trust, you'll still quickly find yourself overwhelmed by the sheer number of strong stock picks out there.
The problem isn't finding stock recommendations. It's finding recommendations that are right for you.
One of the most basic tenets of investing is also one of the hardest to put into practice: When you pick stocks, you should be aware of how much risk you should take on and choose stocks that combine to give you acceptable risk levels in your overall portfolio. Take on too much risk and you jeopardize your life savings unnecessarily. Don't take on enough risk, and you could miss out on reaching what should have been attainable financial goals.
But the problem with most stock recommendations is that they leave out this crucial risk-assessment step. By ignoring risk and focusing solely on a certain desirable metric -- whether it's growth potential, dividend yield, or cheap valuation -- you can end up with the wrong mix of stocks to achieve your goals.
When you need risk
To illustrate the point with a real-life situation, turn the clock back three years. In the depths of the financial crisis, the stock market had melted down. Companies of all sizes, from promising upstarts to well-established stalwarts of industry, found themselves on the edge of collapse.
Even among stocks that had held up reasonably well, investors were waiting for the other shoe to drop. Green Mountain Coffee Roasters (Nasdaq: GMCR ) had more than doubled from the beginning of 2007 to the end of 2008, but a huge recession seemed to bode ill for expensive single-serve coffee makers. Similarly, with emerging-market growth suddenly in question, MercadoLibre (Nasdaq: MELI ) raised fears of a reversal of fortune for booming Latin America and its hunger for auction-based retail options.
So what did investors do? A huge number jumped onto the sidelines despite having long investing time horizons. And even among those who stayed in stocks, many shifted to more defensive postures, choosing stalwart stocks like Warren Buffett's Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) to provide them with some protection from further declines.
But as it turned out, most of those choices were dead wrong. Even though defensive stocks largely did well in the run-up after March 2009, their returns paled in comparison to what Green Mountain and MercadoLibre delivered. And if you were a growth investor who abandoned ship out of fear, you made a costly mistake.
When you need security
Fast-forward to the present day, and market psychology has almost completely reversed. With stocks having doubled in value, everyone's jumping into high-growth stocks -- stocks like MercadoLibre and Green Mountain, which have already seen huge jumps in their prices.
Meanwhile, companies that offer attractive value but not necessarily huge growth are going ignored. Berkshire has gone nowhere for the past two years, and just as they did in the late 1990s, investors are getting impatient and looking for faster profits elsewhere. Similarly, Corning (NYSE: GLW ) has its glass products in some of the most popular smartphones and other electronic devices in the world, yet investors prefer chip makers and producers of sexier components, and the company has missed out on the recent run.
Obviously, I don't know if high-growth stocks are poised to plunge. But if you're a conservative investor and don't need the multibagger returns that those stocks can provide, then taking that risk rather than choosing more appropriate, lower-risk investments may be a bad move -- no matter what happens.
Know what you need
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