To invest or not to invest? That is the question.
It can be tempting to jump on the bandwagon and follow whatever the crowd seems to be doing when it comes to short-term investments in that latest “hot” stock promoted on Social Media. Sometimes, however, following the crowd may lead to significant investment losses.
Retail investors may seek to profit from volatile markets by buying individual stock, including stock in heavily-promoted companies discussed in social media, ratings websites, message boards, chat rooms, and discussion forums.
A Library of Congress report identified several investing behaviors that can undermine investment performance, including behaviors that involve short-term investing. Investors should keep in mind these behaviors when considering investing in a volatile market, including:
- Investing in Bubbles or Manias. Financial “manias” or a “bubble” is the rapid rise in the price of an investment, reflecting a high degree of collective enthusiasm or exuberance regarding the investment’s prospects. This rapid rise is usually followed by a contraction in the investment’s price. The contraction, or “panic” occurs when there is wide-scale selling of the investment that causes a sharp decline in the investment’s price.
- Momentum Investing. Another investing strategy that can pose high risks for retail investors is “momentum investing.” An investor using a momentum investing strategy seeks to capitalize on the continuance of existing trends in the market. A momentum investor believes that large increases in the price of an investment will be followed by additional gains and vice versa for declining values. If that belief turns out to be incorrect, it can lead to significant losses.
- Noise Trading. A third related strategy is “noise trading.” Noise trading occurs when an investor makes a decision to buy or sell an investment without the use of fundamental data (that is, economic, financial, and other qualitative or quantitative data that can affect the value of the investment). Noise traders generally have poor timing, follow trends, and overreact to good and bad news in the market.
Be careful investing with margin, options, or short sales
All investing has risks. If you invest using margin, options, or short sales these risks may be magnified. Margin trading (using borrowed money to buy securities) can be very risky and is not appropriate for every investor.
Options (contracts to buy or sell a stock for a specified price on or before a certain date) like other securities carry no guarantees. Investors should be aware that it is possible to lose all of your initial investment, and sometimes more. Option holders (buyers of option contracts) risk the entire amount of the premium paid to purchase the option. If a holder’s option expires “out-of-the-money” the entire premium will be lost. Option writers (sellers of option contracts) may carry an even higher level of risk since certain types of options contracts can expose writers to unlimited potential losses.
Short sales involve the sale of a stock you do not own (or borrow for delivery). Short sellers believe the price of a stock will fall. If the price falls, short sellers buy the stock back at the lower price and make a profit. However, if the price of the stock rises, short sellers will incur a loss when they have to buy the stock back at a higher price. Short sales can expose an investor to the possibility of unlimited losses, since a stock can theoretically keep rising indefinitely.
Market and broker-dealer protections for volatile stocks
The national securities exchanges and FINRA have rules designed to address market volatility in stocks listed on a national securities exchange. The “Limit up-Limit Down” rules are designed to prevent trades in these stocks from occurring outside a specified price band. This price band is set at a percentage level above and below the average price of the stock over the immediately preceding five-minute trading period. If a stock’s price moves outside these price bands for more than 15 seconds, trading in the stock will be paused for five minutes.
Also, broker-dealers may reserve the ability to reject or limit customer transactions. This may be done for legal, compliance, or risk management reasons, and is typically discussed in the customer account agreement. In certain circumstances, broker-dealers may determine not to accept orders where a transaction presents certain associated compliance or legal risks.
Beware of the potential for market manipulation on online platforms.
Fraudsters can use online platforms to spread false or misleading information. Fraudsters may try to manipulate a company’s stock price (either positively or negatively) and to profit at investors’ expense.
For example, in a pump and dump scheme, fraudsters pump up a company’s stock price by making false and misleading statements to create a buying frenzy, and then sell shares at the pumped up price. In other instances, fraudsters start negative rumors urging investors to sell their shares so that the stock price plummets and then the fraudsters take advantage of buying shares at the artificially low price.
For more information and to safeguard your assets, please visit the SEC’s website.
About CMR & Associates + PolicySmart™
CMR & Associates’ risk management consultants provide independent retirement and insurance advice by reviewing your current plans to improve coverage and reduce cost. Through CMR’s proprietary database – The CMR Database® (comprised of some 13,000 brokers and specialists globally), we maximize access to the insurance and retirement industry for greater options that will translate to better coverage and lower cost.
Please email CMR & Associates or call 877-447-4301 or 212-447-4300 for more information.