by Archie M. Richards, Jr., CFP^®
March 27, 2006

Warren writes, "Two years ago, on a friend's advice, my wife and I bought 500 shares of E-Smart Technologies (ESMT) at $2 a share, totaling $1,000. Yesterday, the stock closed at only 7 cents a share. Should we hold or "cut bait?"

At this writing, Warren, the last price was only 6 cents a share. The bid - the price at which you could sell the stock - is 5.25 cents. Your proceeds would be $25.25 (500 shares times 5.25 cents). If the broker's commission is $25.25, you'd come out with nothing. You're better off just holding.

But don't hold your breath about recovering your money.

By the way, trading low-priced stocks is expensive. The price at which you could sell the stock (the bid) is 5.25 cents, as mentioned. The asked price, at which you could buy the stock, is 9 cents. The difference (3.75 cents) is called the "spread." If you bought at 9 cents, the price would have to rise by 71 percent just to break even on the spread. It would have to rise more to pay for the two commissions on buying and selling and still more to make a profit for you.

Okay, back to whether you should sell. Let's say you sell another stock or a mutual fund for a $1,000 long-term profit. Without an offsetting tax loss, you'd pay a federal capital gains tax of $150 (15 percent of $1,000). The sale of ESMT, even if you receive no cash, would offset the gain and avoid the $150 tax. But if you continue holding ESMT and the price falls to zero, ask your broker to send you a letter asserting that the stock no longer has value. This you can use as a tax loss. Now about taking investment suggestions from friends: Let's say your friend has used a barbecue grill for some time. He considers it a good value for the price and recommends it to you. If you need a grill, you're wise to follow his lead.

But when your friend buys a stock, there's nothing he can use or touch. The company's past and present matter less than people think. What matters is the future. The stock's price is based on the company's earnings prospects, as evaluated by everyone who takes interest in the company. If the evaluations are extremely favorable, the buyers may not be taking potential bad news into account.

Go to www.BigCharts.com to see the price trend for E-Smart Technology. Type ESMT in the symbol box. Push Enter and request a chart for 3 years. Note that within a two-month period around February 2004, the price jumped from 75 cents to $2. You bought it near the high, when the buyers evidently were thinking about nothing but good news.

But the sellers were thinking about bad news, all right; that's why they got out. Whenever you buy an individual stock, ask yourself, "If this stock is such hot stuff, why are the other guys selling?"

Once more in BigCharts.com, call up a 3-year chart for VTI, an exchange-traded fund of over 3,000 stocks representing all publicly-held U.S. stocks, big and small. Since February 2004, including dividends, VTI has gained about 20 percent.

If you had bought VTI in February 2004, your $1,000 would now be worth $1,200. By buying ESMT instead, you didn't lose just $1,000; you lost $1,200.

That loss is gone forever. Most of us are unlikely to choose a succession of individual stocks that will outperform the entire market.

In contrast to ESMT, the current quote on VTI is $129.34 bid - $129.38 asked. The 4-cent spread represents a tiny difference of only 3/100ths of one percent!

Owning VTI is like owning a tiny piece of America. It's less risk and a lot better return than any single company that your friend and your friend's friends think will turn into gold. It's not a bad idea to avoid individual stocks altogether. Stick to low-cost mutual funds and ETFs.

Oh yes, and knock off taking investment advice from friends.