Yes, Individual Stocks Are Hot; Make Sure You Aren’t Burned

In three days last week, shares of Chatsworth-based diode maker MRV Communications soared from $41 to $59. Electronic Arts, the game software company, jumped $5.50 to $34.50 in one day. Tiffany & Co., the upper-crust jewelry retailer, ended the week at $77, up from $66 a week earlier.

For the typical stock mutual fund, meanwhile, the change in share price last week--as the stock market overall again hit record highs--was measured in dimes, not dollars.

That’s the way it’s supposed to be with mutual funds, of course: Your money is pooled and spread among many stocks, giving you diversification and lowering your risk. “Get rich slowly� is the funds’ marketing slogan.

But let’s face it--mutual funds are downright boring in a market where some stocks are jumping 20% or more in a single day, a not uncommon occurrence in this wild bull market. If you want action today, the place to be is in individual equities.

This isn’t a sales pitch, just a recognition of reality. And more small investors seem to be tuning into that reality. There is plenty of evidence that Americans are becoming much more interested in individual stocks, after heavily favoring mutual funds for their investment dollars since 1990.

Discount brokerages, which cater to do-it-yourselfers, report that new-account openings are rocketing. Investment clubs, which pool members’ dollars to buy individual securities, are forming at a record pace nationwide.

What’s more, the surge in prices of smaller stocks on the Nasdaq market over the past two months is a classic sign of greater interest on the part of independent investors, who for whatever reason suddenly are willing to take a flier.

Many Wall Street veterans see all of this as a sure sign that the bull market is nearing a crescendo, because investors’ willingness to throw caution to the wind usually rises dramatically just as stock prices peak. “It’s late in this bull market. The craziness has begun,� says William F. Mason, portfolio manager at Cullen Fortier Asset Management in Woodland Hills.

But he also concedes that “the craziness may have a long way to go� before the market’s run ends. As Japan demonstrated in the late 80s, stock market bubbles can get very big before busting.

The independent investor’s desire to play individual stocks may well worry some market veterans, but that smacks a little of Wall Street’s usual condescending attitude toward small investors. The truth is, independent stock pickers can do quite well for themselves--and far better than mutual funds may provide--with the right combination of skill and luck.

None other than Peter Lynch, the legendary former manager of the Fidelity Magellan stock fund, has been saying as much for many years. His basic message, espoused in his latest book “Learn to Earn� is that a diversified portfolio of 10 to 15 stocks can make you quite wealthy in time. “A few big winners a decade is all you need,� he says. “If you own 10 stocks, and three of them are big winners, they will more than make up for the one or two losers and the six or seven stocks that have done just OK.�

But Lynch is talking about the odds for people who really do their homework, not those who bet a huge sum on one or two stocks that they know little about.

And that’s the great danger in this market: that investors who really aren’t cut out to own individual stocks will get pulled into a few high-risk, hot stocks du jour. The bait, often enough, is likely to be a “cold call� from a stock broker the investor has never heard of.

For the uninitiated, a cold call is an unsolicited phone call you get at home or at work from a broker trying to drum up business. It’s a legal call, as long as the broker keeps the pitch within a certain framework. As an investor, you of course have no obligation even to listen--you can just hang up.

But for reasons that baffle securities regulators, but probably not psychologists, many people listen to cold calls. And a surprising number of people agree to send brokers money, to invest on whatever tips the brokers are giving.

“I am amazed that cold-calling is a successful activity,� admits Mary Schapiro, the tough new head of NASD Regulation, the self-policing unit of the securities industry. “Most people wouldn’t send money to a voice over the phone for anything else,� she notes.

In the best case, Schapiro says, a broker won’t use cold calls for any purposes but to make introductions, offer to send some investment research, or invite the investor to meet one-on-one to discuss financial needs.

In the worst case, a broker touts a single stock, urging the investor to get in “immediately� because the stock is “ready to soar.�

That kind of pitch is, in fact, illegal. Major brokerages don’t officially allow those kind of calls. But they are the stock in trade of sleazy brokerages, too many of which unfortunately call Southern California home. And the NASD, along with the Securities and Exchange Commission, have very limited ability to detect and stop such calls.

Cold-calling “is very difficult to police,� Schapiro concedes.

One of the worst abuses involves pitches to buy stocks that the broker’s firm is in the process of manipulating, generally thinly traded small stocks on the Nasdaq market. By trading a stock for its own account, a brokerage can help push the price higher.

The firm’s brokers then cold-call potential customers, asking if they’ve noticed “how much stock ABC has moved in recent days� and suggesting there is “more to come.� The suckers who take the bait often end up paying inflated prices to buy the shares directly from the brokerage--which, naturally, earns a handsome profit. More often than not, the stock quickly becomes a one-way ticket down, and the cold-callers move on to other issues.

In a market where individual stocks can rocket to the stratosphere--sometimes even for good reasons--how do you deal with the unsolicited, yet inviting, hot tip? Some Wall Streeters suggest turning the tables on the brokers: grill them on their experience, the firm, why this stock is such a great idea, etc.

But John Markese, director of the American Assn. of Individual Investors in Chicago, says the slickest brokers “will have good answers for every question, and who knows if they’re true.� The better idea, he says, is simply this: “Never buy anything from anyone you don’t know.�