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Talk Yourself Out of These Risky Investments

Joanne Cleaver
Mascots dressed as characters from the mobile video game "Candy Crush Saga" pose during the IPO of Mobile game maker King Digital Entertainment Plc on the floor of the New York Stock Exchange March 26, 2014. REUTERS/Brendan McDermid

Before Facebook went public in 2012, Mike Bonacorsi's clients wanted to know how they could get in on the hot initial public offering. They were on Facebook, their friends were on Facebook and although the company's revenue model was still emerging, they wanted a slice of it.

Bonacorsi, an Amherst, New Hampshire-based financial planner, talked common sense into those clients. Some didn't realize IPO shares are typically bundled by the investment bank handling the IPO and are presold to institutional investors. Clients also didn't fully understand how volatile the stock would be immediately after the IPO. Bonacorsi found himself explaining both IPO basics and the importance of not plunging into an iffy, if headline-grabbing, investment.

It's easy to be entranced by the latest shiny investment. Financial advisors say clients often contact them about a hot sector or investment they've been hearing about, worried that they're missing a once-in-a-lifetime opportunity.

[Read: 3 Big Secrets You Should Tell Your Financial Advisor .]

Ron Weiner, a certified financial planner and founder of RDM Financial Group, based in Westport, Connecticut, has endured a variety of client fixations over the years. IPOs are one of the most common, he says. He recently had to redirect a client determined to buy into the IPO of King Digital, the digital game outfit behind Candy Crush. "I told him, they're basing the valuation on price times sales because there are no earnings," Weiner says.

Exotic bond funds are another distraction. Leveraged closed-end bond funds inject additional risk into a typically staid investment tool because both the trading price and the net asset value fluctuate. Weiner advises against investing in such funds.

Some investors are mesmerized by exotic exchange-traded funds, such as those comprised of stocks from a single country or a single sector, thus concentrating risk.

And some clients are seized with the notion of blending investing with social change. "They'll say, 'I just want green stocks,'" Weiner says.

"It's a herd mentality," says Victor Ricciardi, assistant professor of financial management at Goucher College and co-author of the upcoming book "Investor Behavior."

His research pinpoints several common investor delusions. One is the "hot hand fallacy," a superstitious outlook that convinces people they're on a winning streak, when, in fact, the odds have simply been in their favor and could turn at any moment. Overconfidence in men is a well-documented factor, and one that Ricciardi discusses in his book. "Male traders tend to possess a higher level of unsupported confidence," he says.

"You attribute the market trend to your own success, and then you are confident in something you can't control," Ricciardi says.

Old-fashioned peer pressure is not to be underestimated. Golf buddies, it turns out, are just as much of a force as high school friends -- except the stakes are higher when you're pursuing bragging rights about an investment kill.

[Read: The 5 Deadly Sins of Investing.]

Here's how to talk yourself down from a headlong jump into the latest, greatest thing.

-- Can you even get in on it? Clearly, there's no point in getting excited about an investment you can't buy. Shares in pre-IPO companies are only available to certain types of investors, through well-established venture and banking channels, Bonacorsi says. Despite the breathless pre-IPO run-up, there's no way for individual investors to buy shares in most IPOs.

-- Do you understand how this investment purports to outperform? Companies and funds concentrated in just one product or sector are likely to crash as fast as they rose, Weiner says. Meanwhile, some supposedly hot sectors never get past lukewarm. Weiner cites biotechnology companies that have been raising money for years and have yet to bring products to market, or worse, have seen their products wandering through the wilderness of the Federal Drug Administration approval process.

-- What type of specialized advisor can provide additional guidance for this potential acquisition? If the transaction requires a specialized credential or access outside the scope of your primary advisor's operations, don't hesitate to ask for a referral. That's much preferable, Bonacorsi says, to responding to pitches from investment brokers you've never met.

-- Likewise, advisors say, are you willing to do some research and unearth factors that might drive or derail this supposedly sure thing? There's nothing like discovering an identical situation that went south to throw cold water on a hot idea.

You can take a cue from Ricciardi. He avoids owning individual stocks and keeps about $10,000 in his "personal high-risk pool" that he tosses at irresistible opportunities.

[See: 10 Risky Investments Billionaires Can't Resist.]

But his secret weapon is understanding his own investing psyche well enough to realize he has to burn off the occasional urge to gamble. Ricciardi goes to the horse track a few times a year and bets $100 each time. "If I can get a whole day of fun out of losing $100, that's fun," he says. "That's how I apply my own investment therapy to myself."

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