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5 Questions to Ask Before Acting on a Hot Stock Tip

Scott Westcott

NEW YORK (MainStreet)—Personal finance expert Andrea Travillian is living proof that anyone can get burned by a "hot" stock tip.

Back in 1996 while Travillian worked as a finance intern, the talk at the office water-cooler turned to investing. One of Travillian's co-workers was high on Value Vision Media (VVTV) as a can't-miss stock. The company was in the emerging online shopping channel space.

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Travillian jumped in without looking – and lost. Value Vision Media struggled to keep up with QVC and other competitors, and the stock lagged. (The company has fallen from a peak valuation of more than $2 billion to about $200 million in 2013.) Travillian only lost about $300 in the deal, but the lessons she learned have lingered.

"First of all, sleep on it," says Travillian, founder of Smart Step, Inc., a financial advisory firm. "Never jump into any investment the second someone tells you to do it. Putting 24 hours between you and the decision allows you to get over that first initial rush of emotional excitement."

So before acting on a tip from friend, family member or business associate, get a good night sleep -- and then ask yourself five tough questions.

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Does the stock fit my strategy? Buying off a tip is often akin to an impulse buy at the grocery store checkout counter – grabbing that Snickers bar doesn't fit with your diet plan, but it still often ends up in the shopping cart. Framing the question of whether to act on a hot tip in relation to your overarching investment strategy, tempers the impulse to buy and allows you to view the potential purchase more rationally. "Ask yourself, does this stock meet the criteria I've established for myself within the guidelines of my plan?" says Eric Dahm, who leads the wealth management practice for Human Investing in Lake Oswego, Ore. If the answer is yes, it might be worthwhile to dig a little deeper. If not, take a pass. And if you don't have a plan, use the tip as a motivator to get one started.

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Do I know the company? So if the stock passes the up-front strategy test – or if your impulse to buy simply hasn't cooled – ask yourself if you know what you are buying. Dahm says that question can sometimes lead to discovering you are already on board. "You may already own mutual funds or ETFs that contain the stock inside their holdings," says Dahm, noting that often-recommended Apple is the top holding of some of the most common mutual funds in the market. If you don't own it, or are tempted to grab more, it's time to do some research. Jeffrey S. Vollmer of Hyde Park Wealth Management in Cincinnati suggests looking at the company's cash flow, PEG ratio, and whether it has momentum. He suggests avoiding stocks trading below $5 per share or those dependent on approval of a new product or service that may never come through.

Would you buy the company's product or services? After initial research, this next question offers a good reality check, says John A. Moore, Ph.D. , an associate professor of finance and economics at Walsh College in Troy, Mich. Although the question may not always be relevant, (most of us will never buy a super-collider or new weapons defense system) it often can be telling. "Warren Buffet maintains that he won't invest in a company that he doesn't understand," Moore says. Also consider how many products the company has in the market or in development. "If it only has one or a few, be careful," Moore says. "If a competitor can provide the same product better, or the product can be rendered obsolete by improved or new technology, it could lose its value rapidly."

Can I afford to lose? Stock tips are rarely for the old-stand-by blue chips, but rather for startups and companies that are thought to have big upside potential. With that typically comes real risk that instead of rocketing higher, the stock just might take a major nosedive. If you do plan to buy, establish how much you are willing to lose if the company goes belly up or struggles mightily. And make sure that the stock will make up only a small part of your portfolio.

"If you do decide to follow the tip, build in some protection if you are wrong and the stock goes down," says Laurie Itkin, a stock and options trading coach and investment advisor. Itkin suggests that instead of buying shares of the stock outright, considering selling an out-of-the-money put option, which is an option to sell assets at an agreed price on or before a particular date.

Will I lose a friend? It's a question outside the direct realm of investing, but one worth asking just the same. The old adage of never do business with friends and family, can frequently extend to investing as well. What begins as a friendly tip can sometimes hurt a relationship if the stock plummets. On this front, Volmer is blunt. "Ask yourself – is the tipper a friend I wish to keep? If so, avoid the stock."

Others are not as definitive on the issue, but point out that the impact on a relationship is something worth considering prior to making the buy.

"The proverbial 'hot stock' tip has a long and storied history," says Moore, the Walsh College professor. "However, at its core, it is often a transaction of trust rather than one of knowledge. All investors, regardless of whether the source is a trusted friend, should only invest based on their knowledge of the facts, Knowledge is the best asset for any investor. Remember, if it sounds too good to be true, it likely is."

--Written by Scott Westcott for MainStreet

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