3 Words You Won't Hear From Your Broker

Brokers are all entitled to their opinions, but keep this in mind before you base investment decisions on their advice.

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Shortly before Facebook’s IPO on May 18, 2012, I received a call from a reader of my books. Her broker had just called her with great news. He was able to get her a small allocation of Facebook stock. She wanted to know if she should buy and then could “flip it and make a profit.”

In response to my questions, she told me she was a struggling single mom, who lived paycheck to paycheck. She had a small 401(k) account and modest savings. She was hoping I would say “yes,” because “the profits would be really meaningful to me and my kids.”

She was very disappointed in my advice. I recommended against the purchase. I told her I had no idea whether Facebook would take off or tank. There certainly was the chance she would be giving up the possibility of big gains, but there was also the specter of large losses. My bottom line was that she could not afford the risk.

She was so upset I doubt if she heard the rest of my reasoning. Logically, I explained, the underwriters priced the IPO at $38 per share factoring in all publicly available information about Facebook known at the time. I saw no reason to believe the stock was mispriced. Finally, I told her I didn’t believe in buying individual stocks. The expected return of Facebook is the same as the category of stocks to which it belongs, but with substantially more risk.

Individual stocks have what is called “idiosyncratic (or unsystematic) risk,” which describes risk unique to that particular stock (like the death of Steve Jobs and Apple). This risk can almost be eliminated through broad diversification. I don’t understand why investors would take on significantly more risk for no higher expected return.

On August 17, 2012, Facebook stock closed at $19.05.

Prior to the IPO, it seemed like everyone had an opinion about the prospects for Facebook stock. Some thought it was seriously overpriced (they were right) while others thought it was a great buy (they were wrong).

Nigam Arora was in the latter category. He wrote a blog dated January 30, 2012, in which he stated that: “As I have previously written, it’s a no brainer to back up the truck and buy as many shares of Facebook as you can get in the IPO.” He believed the “probability is very high” that investors in the IPO would have opportunities to sell their stock at a “substantial profit.” Those who held their shares could see how the stock was trading and then decide to hold “or take profits.” Arora based his “qualitative analysis” on a review of 30 years of data in IPOs.

Subsequently, on May 18, 2012 (the day when Facebook started trading), Arora wrote another blog in which, among other recommendations, he advised his subscribers to cancel orders to buy Facebook in the open market.

He certainly seemed like a credible source. He describes himself as an engineer and nuclear physicist, who founded two Inc. 500 companies and was involved in over 50 entrepreneurial ventures. He is the chief investment officer of The Arora Report “which publishes four newsletters to help investors profit from change.” His web page (www.thearorareport.com/PERFORMANCE) indicates impressive returns from his model portfolios.

Brokers and many others in the financial media love to give their opinions about the economy, the direction of the markets, and the prospects for particular stocks. Sometimes they are right and sometimes they are wrong. They are all entitled to their opinions, but keep this in mind before you base investment decisions on their advice. Markets are random and efficient. Stock prices change based on tomorrow’s news. No one knows tomorrow’s news. The most accurate answer to questions concerning the projected price of any individual stock is: “I don’t know.”

Those are the three words you are unlikely to hear from your broker.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published on December 27, 2011.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

Updated on 8/29/2012