Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a beginning or experienced investor, these weekly updates are designed to give you specific stock investment advice. Each Investor Toolkit update gives you a fundamental piece of investing strategy, and shows you how you can put it into practice right away.

Today’s tip: “You may have a chance of getting lucky with one hot stock pick, but make sure you protect yourself by making it a limited portion of your portfolio.”

Most successful investors know better than to invest any money in the stereotypical “hot stock tip” —the gotta-act-quick buy recommendation that comes from a friend (or a friend of a friend).

Stocks like these are supposedly sure to make you a lot of money, but they virtually never succeed. Some of these recommendations start out as honest opinions of investors who know just enough to jump to conclusions about a stock’s outlook. However, some of these investors may have come under the influence of dishonest stock promoters and professional swindlers.

Of course, you may feel your work gives you special expertise for investing in your own industry. Lots of tech company workers, for instance, feel that way. They have strong feelings about which tech firms are most likely to thrive and which are apt to fail. But the strength of that feeling can mislead you, for a couple of reasons.

First, no single individual can possibly know all you’d need to know to foresee which tech stocks are likely to beat out all their competitors. That’s true of stocks in any industry.

Second, the success or failure of any single tech stock is due to a variety of events that will happen in the future. The company may start out with a promising business plan. But it needs all sorts of things to prosper in the long run: the right employees, a favourable economic and regulatory climate, a favourable competitive situation, favourable research outcomes, adequate financing, perhaps the right merger partner or acquisition—the list is near endless. This also is true of stocks in any industry.

Of course, you may at times pick a stock that you think will rise tenfold or more, and it does precisely what you expect and then some. But you need to brace yourself for the fact that you may be wrong.

So if you feel you have stumbled across a sure thing in the market, you should look more closely.

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Making a lot of difficult sell-or-hold decisions

Do examine things carefully, but don’t expect perfection. If everything seems to check out reasonably well, add the stock to your portfolio. Ordinarily, we’d limit any one initial purchase to 5% or less. But you wouldn’t necessarily stick to that rule if you justifiably feel this strongly about a particular stock. You might even want to start it at 10% of your portfolio.

It’s still a good idea to keep your portfolio well-diversified across the five main economic sectors, despite your big holding in this one stock. That’s especially so if the favoured stock is in either of the two most volatile sectors, Manufacturing & Industry or Resources & Commodities. If you invest 10% of your portfolio in a favourite manufacturer, you should sell off other less favoured manufacturing stocks to keep your manufacturing exposure below, say, 35% of the total.

After that, you need to monitor the stock much more closely than your other holdings, because of the size of your investment. You’ll need to make a lot of difficult sell-or-hold decisions as the favourite stock’s fortunes wax and wane. If it rises faster than your other holdings, you’ll need to decide if you’ll sell some from time to time or if you’ll let it represent an ever-growing portion of your portfolio.

We have a number of portfolio management clients who have half or more of their portfolios invested in a particular stock. In many cases, the stock is one of Canada’s top five banks and was left to the client by a parent who may have inherited it. Selling the stock is out of the question. After all, “it’s been in the family for generations.” In fact, the client may leave instructions to sell the other stocks in the portfolio to pay any capital gains taxes owed on his or her death.

Plunging into a single stock can pay off nicely for several generations if you pick stocks that have performed as well as Canada’s top five banks have over the years. Unfortunately, stocks that have done as well as the banks, for as long as the banks, are extraordinarily rare.

COMMENTS PLEASE—Share your investment knowledge and opinions with fellow TSINetwork.ca members

Have you ever received a stock tip from a friend or acquaintance that actually paid off with a run of success? Do you have a specific example of one that looked good initially but ultimately was a disaster? Let us know what you think.