Why do you buy a particular stock?

Check the choice you most agree with…

___ The stock has bottomed.

___ The stock is dirt-cheap.

___ The stock is offering a huge dividend.

___ A majority of analysts have rated it a “buy.”

___ It offers an attractive return in the long term.

Buying into a company because it has bottomed is a non-sequitur. You can’t really know when it has bottomed. Even if it has dropped 95 percent, you could see it drop another 50 percent.

Buying a cheap company just because its price is low is tempting… but not smart. Many companies are cheap for a reason. Some aren’t. The former you should ignore. The latter are much better investment opportunities. (More on that in a few seconds.)

Huge dividends lure many investors. But understand that some dividends are high because investors are fleeing the stock… lowering the share price… and thus raising the dividend yield. Before you buy, you have to ask yourself why so many other investors are selling the stock. It’s only a matter of time before many such companies reduce their dividend rates.

Highly rated companies are safe bets, right? Two things you need to know. First, many analysts engage in ratings inflation. If the company doesn’t stink to high heaven, it gets a “buy” rating from Wall Street. Second, if all (or most) of the analysts are rating the company high, there’s no room for them to upgrade it – and news of a ratings upgrade brings in new investors in droves. I prefer analysts to be lukewarm (at best) about a company. If the company is any good, ratings will rise, bringing in new investors who will drive up the price.

The only reason to buy into a company is if you think it will give you good returns in the long term compared to other investments. Such companies may go down some in the short term – but they have demonstrated an ability to grow profits, manage their cash prudently, are in pretty good sectors, and are reasonably priced. Getting a great price on companies like these is not necessary, although in this market it’s not hard to find them at 40-60 percent off. All the better.

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