5 reasons why you shouldn't buy a stock just because a big-name investor owns it

Over the years, I've overheard so many investors claim that a stock is a 'safe' or 'good' investment just because Temasek or some other big-name investor has a stake in it.

(On a side note, I find it paradoxically amusing that a few retail investors who are so confident of Temasek's backing are the same ones who grumble about Temasek mismanaging their CPF monies. Except Temasek has stated that it doesn't manage them.)

I mean if Temasek, Li Ka-shing, or Warren Buffett make an investment, surely they - and their phalanx of advisors and analysts - must have done their utmost due diligence, right?

Well, yes. When a big investor makes a multimillion or multibillion-dollar investment, you can be sure that they've done their research and analysis to the best of their ability before committing that amount of money. However, just because a big-name investor makes an investment, it doesn't mean you have to follow suit. Why so?

Here are five reasons why you shouldn't buy a stock just because a big-name investor owns it:

1. YOU HAVE DIFFERENT FINANCIAL NEEDS AND GOALS

Warren Buffett is a multibillionaire and one of the richest men in the world, so you can be sure that he's not investing to save up for his retirement. (Actually, I don't think he'll ever retire.) A business magnate is investing because he may have plans to do a hostile takeover of a rival company. A sovereign wealth fund is investing to grow a nation's wealth and protect its national interests. All of them are investing for a range of different business, strategic, or economic reasons.

On the other hand, you have your own unique financial needs and investment goals. You could be investing because you want to prepare for retirement, or to grow a stream of passive dividend income, or to save up for your children's education, or to fund a purchase a few years down the road. Therefore, what makes sense as an investment to a big investor may not necessarily make sense for you.

For example, if you're looking for dividend income, then an investment in Apple may not be the most suitable for you since it pays such a low yield (~1.5 per cent) - regardless of Buffett owning the stock. So always ask yourself whether a particular investment suits your individual needs and investment goals. If not, then it may be better to pass it up.

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2. YOU HAVE DIFFERENT RISK TOLERANCES

Everyone reacts to uncertainty differently. Some people love the thrill of exploring a new city, while others get a heart attack just because the taxi driver decided to take a different route to the office this morning.

Investors too have different tolerances to uncertainty and risk. Some investors have no qualms investing in a hyper-growth stock that may crash at the first sign of trouble. While others can't bear the thought of losing any money at all and prefer sticking to safe investments like government bonds.

Ask yourself: How would you react if the value of your investment dropped by 5 per cent in a year?

What if it dropped by 10 per cent?

And what if it dropped by… 40 per cent?

Knowing your individual risk profile gives you an idea of the kind of investments you should be looking at and those you should avoid.

For example, investing in Netflix just because you heard some investment guru owns its stock is probably a bad idea if you have low tolerance for risk. Just to give you an idea, Netflix went from a high of US$386 (S$526.53) and crashed all to the way to US$254, before rebounding to US$310 - all within the past 12 months:

'Hey Brad! Check out my design for the new rollercoaster!'

Can you comfortably handle this sort of volatility? If not, then you may be better off with a safer, steadier kind of investment.

3. YOU HAVE DIFFERENT TIME HORIZONS

Warren Buffett famously said that his favourite holding period is 'forever.' While no one thinks that he'll actually last that long, it goes to show that he's an extremely long-term investor. One of his most profitable stock investments, Coca-Cola, was bought in 1988. So when Buffett buys a stock, he's prepared to wait 10, 20, 30 years or more to fully realise his investment. Are you willing to wait that long? Can you actually wait that long?

This goes back to our first point about knowing your financial needs and investment goals. For example, if you're nearing your retirement and need some passive income to support your living expenses, then investing in a stock that takes five years to grow and pays no dividend in the meantime wouldn't make sense for you. But a REIT that pays a steady dividend every three months might be more suitable.

4. YOU HAVE VASTLE DIFFERENT PORTFOLIOS 

Oftentimes, you hear of big investors taking a multimillion or multibillion-dollar stake in a company and it looks like they're throwing their entire weight behind their investment. Seeing this, some retail investors decide to follow suit and invest heavily in the same stock, thinking: 'If big-name investor can invest $1 billion in this stock, it must be a really good investment!'

But what some retail investors fail to remember is that, for big investors, even a billion-dollar investment might only account for a small percentage of their portfolio.

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In 2016, Temasek invested US$500 million for a stake in Alibaba Group. While that is certainly an eyewatering amount, it only accounted for about 0.3 per cent of Temasek's net portfolio of $242 billion that year. So even if Alibaba somehow managed to go belly up, it would hardly make a dent to Temasek's overall portfolio. (In case you're wondering, Alibaba has returned 275 per cent since its IPO in 2014.)

A mega fund like Temasek also has the resources and ability to manage a well-diversified portfolio of different investments spread across global markets. But an individual retail investor like you and me can only probably monitor a portfolio of 10 to 20 stocks before we start to lose focus. So making one bad investment would most certainly hit us much harder, especially if we allocated a huge chunk of our portfolio to the wrong stock.

Another point is, due to the massive size of their portfolios, big investors are also restricted to investing in larger companies in order to generate decent returns. So following them exclusively would lead you to ignore smaller, faster-growing stocks that might give you a higher return as a retail investor.

5. YOU HAVE DIFFERENT ACCESS TO INFORMATION 

This is the chief reason why people copy big-name investors in the first place - because they trust that big investors have better access to research, analysis, and information that allows them to pick better investments. In other words, they have a larger circle of competence and an informational advantage.

However, this is also a double-edged sword. Because if you simply rely on copying a big investor - and never do your own research - then you're unaware of the reasons why a big investor is buying a stock and the inherent risks that come along with it. You'd also have no idea what their exit strategy is, and when or why they may decide to sell a stock.

For example, Temasek invested in Hyflux in 2003 as part of an 'initiative to support the growth of small and medium-sized enterprises in promising sectors.' By 2006, Temasek exited the company after 'completing its investment objectives.' So unless you were privy to the same information that Temasek had, you'd have no idea what its exact entry and exit strategies were with regards to Hyflux.

(Assuming you could have invested in Hyflux back then; it only went public in 2007.) And even if you had access to the same information, ask yourself if Temasek's investment objectives would have matched your personal goals? I highly doubt it.

You could argue that you don't care what a big investor's objectives are as long as there's money to be made. That's true - it's all fine and dandy when you follow blindly and still walk away with a profit. But not every investment will be a win - even for the big boys.

So if you had lost money, you'd be left blaming and cursing the big investor for making such a bad mistake. When the reality is maybe you didn't fully understand the risks and the rationale of the investment in the first place… but you still chose to jump in.

THE FIFTH PERSPECTIVE

The main reason why I wrote this article is because I think retail investors have to become more astute and discerning whenever anyone pushes a stock or bond or whatever as a good investment simply because some big-name investor also owns it.

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Ask yourself: Do you understand this investment? Is it within your circle of competence? Do you fully understand its risks? Does it even suit your investment goals, risk profile, and time frame?

I'm not saying that we should entirely ignore what the big investors are looking at; they're a great source of investment ideas. There are sites like GuruFocus.com which track the portfolios and stock investments of the most famous investors in the world.

But understanding why a big investor is making an investment is more important than just knowing what their specific investments are. Because at the end of the day, you still need to do your own research and analysis to decide whether an investment is ultimately suitable for you.

This article was first published on The Fifth Person.

All content is displayed for general information purposes only and does not constitute professional financial advice.