Why You're Paying Too Much for These Stocks

Trying to find a great stock sometimes feels like searching for a needle in a haystack. With thousands of companies to dig through, many of which you may never have heard of before, it takes a lot of effort to do the research necessary to try to find tomorrow's big winners.

As a shortcut, many investors simply wait to hear from Wall Street analysts rather than doing their own research on a particular stock. Like a dog running into the kitchen when he hears you open up the daily can of Alpo, these investors rush in to buy up shares, often without any further thought. What they don't realize, though, is that each time they buy shares after such an announcement, they pay a high cost -- one that eats into their long-term returns.

How information affects prices
The main problem with investing based on any sort of news -- whether it be an analyst recommendation, a positive earnings surprise for a company, or some other favorable event that boosts your stock's prospects -- is that the market prices in such information almost instantaneously. Take a look, for instance, at how these stocks moved on the trading day immediately after these analyst upgrades:

Source: StreetInsider, Yahoo! Finance.

You'll often see similar moves downward in response to announcements that analysts have downgraded a stock. For instance, both Merck (NYSE:MRK) and Starwood Hotels moved down sharply after getting downgraded last week.

You're too late
The impact that analyst recommendations in particular have on stock prices is actually somewhat surprising. With most types of positive news -- earnings that come in better than expected, for instance, or announcement of a successful product launch or research finding -- investors are usually seeing new information for the first time. It makes sense that a stock's price would move up in response to such information, since the news increases the market's assessment of a company's intrinsic worth.

Upgrades and downgrades from analysts, however, don't tell investors anything that they couldn't figure out on their own. Although the analysis is proprietary, it's based on publicly available information. So, news of an analyst upgrade shouldn't change anyone's estimate of a stock's intrinsic value.

Still, the fact that share prices often do react strongly to what Wall Street analysts say reveals the impact that analysts have on supply and demand and the willingness of many investors to follow such recommendations blindly. If most investors did their own research and analysis, then the collective impact of an analyst recommendation would amount to the crowd's responding, "So what? We already knew all that."

The net cost
Instead, investors are willing to sacrifice some of their potential returns in exchange for not working to discover such stocks on their own. That comes with two costs. The most obvious is the extra money you pay up front. By paying 2%-5% more for shares after an upgrade, as illustrated above, you're reducing your eventual return by that amount -- which will add up after years or decades of holding your shares.

More importantly, though, following analysts locks you into a different way of thinking about investing. Analysts make decisions about stocks all the time, and often make recommendations in different directions. If you decide to follow analysts, which ones should you follow? How will you deal with whipsaw recommendations: downgrades coming on the heels of an upgrade? Are you prepared for increases in transaction costs and taxes that result from short-term trading? Trying to answer those questions can prove even more difficult than doing your own research on stocks.

Big price moves after analyst recommendations show the value of beating the crowd to the punch. If you're expending your energy searching for the best investments you can find, you'll earn bigger rewards than those who follow the herd.

For more on smart investing, read about:

• The worst stocks to buy today.
• The wrong way to invest in the right stocks.
• You could easily double your money with these investments.