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Hot Tip Nightmares Bulls and bears aren’t responsible for as many stock losses as bum steers. — Olin Miller Suppose a good friend came up to you at a party and pulled you aside. “You’ve got to keep this quiet,” he whispers when you’re out of earshot of everyone. “I just heard this from one of the directors of Big Wind Corporation and it hasn’t been announced yet. It’s received a takeover bid from the Mighty Gale Company in the United States, and the board has voted to approve it. The offer is for double its stock’s trading price. I told my broker today to buy me a thousand shares. You should do the same thing before the news gets out.” |
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Ask yourself honestly: What would you do in this situation?
The correct response is, of course, the third one. Your friend has received confidential information from a company insider and has acted on it for his personal benefit. That’s illegal, and though people sometimes get away with it, especially if they are not a director or officer of the company, anyone who tries to profit from such privileged information is taking a big risk. If you chose option a. and called your broker to place an order for Big Wind shares, you’d be in the same situation. The reality, however, is that many people would take the risk, sometimes because they don’t know the rules, and sometimes using the rationale that because they “heard it from a friend who heard it from a friend,” they aren’t doing anything unlawful and, anyway, no one is going to be hurt because you bought a few shares. It’s easy to justify immoral behaviour when there’s a lot of money on the table. The fact that insider trading is illegal should be a compelling reason not to act on tips like this. But if that’s not enough to persuade you, try this: Nine times out of ten, you’ll lose money by betting money on hot tips. Why? Because by the time you hear about it, hundreds or perhaps thousands of other people will already be in on the story and will have placed orders for the stock, driving the price higher. As a result, you overpay. Why would a company director do something like that, you may ask? Let’s construct a hypothetical scenario. Suppose this particular director holds a large number of shares in Big Wind. He has just come through a messy divorce and is faced with a huge settlement plus legal bills. He is short of cash and needs to get his hands on some quickly. As a director, he knows that Big Wind is having serious problems. A strike at the European plant that manufactures turbines for the company has put construction of the new wind farm on the east shore of Hudson Bay at least six months behind schedule. Without the revenue from the electricity production that had been budgeted, the company faces a serious cash crunch within a few months. The share price has already started to fall as a result. The director is desperate. He must sell stock to raise the money he needs, but the price is depressed. So he begins a surreptitious rumour campaign, telling a few people that he knows are chronically incapable of discretion that Big Wind is about to be taken over. It works exactly as he expects. The word spreads, the stock moves sharply higher, and he is able to sell his shares at a fat profit—more than enough to pay off his ex-wife and the lawyers, with plenty left over for a vacation in Hawaii. Meantime, when the stock exchange sees what is happening to the share price, it asks the chief executive officer of Big Wind for an explanation. A few days later, the company issues a press release stating that rumours of a takeover bid are completely unfounded and no talks are active or contemplated with Mighty Gale or anyone else. The stock price immediately plunges as panicky investors, some of whom borrowed heavily to buy shares, try to unload. And who’s left holding the bag? The poor suckers who believed the hot tip and bought a couple of hundred shares with the expectation of cashing in on a sure thing. Farfetched? Hardly. Variations of this scenario happen all the time, and there are always easy marks out there to prey on. When it comes to the stock market, the “get rich quick” syndrome is hard to cure. Investors are always looking for the “big score,” that one stock that will make them fabulously wealthy overnight. It appears to be as addictive as gambling. The reality is that it rarely happens that way. You stand a much better chance of making a big score by buying a blue chip stock when it’s cheap and being patient than you do by chasing hot tips. | |||