If you feel the need to invest in “sure thing” hot growth stocks, be sure you’re not gambling away too much of your portfolio

Most successful investors know better than to invest any money in stereotypical “hot growth stocks”, those gotta-act-quick buy recommendations that come from a friend (or a friend of a friend), or an unknown source on the Internet.

Some of these recommendations may start out as honest opinions of investors who know just enough to jump to conclusions about a stock’s outlook. However, some of these naive investors may have come under the influence of dishonest stock promoters or 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 hot growth stocks in tech 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 is also 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.

Bonus: 4 risks of investing in hot growth stocks in the tech industry

Marketing is as hard as inventing: Even a great new product or computer program may fail to overcome the scepticism of retailers and consumers.

Acquisitions can bring “time-bomb” risk: Companies sometimes grow quickly by buying other companies. But it may also be the case that those selling the companies may simply want to bail out of a losing situation.

Major tech stocks also make mistakes: Hot growth stocks in tech that are new technologies often trumpet their deals with major firms, such as Apple or IBM. And it’s true that Apple and IBM have vastly more knowledge and bargaining clout than any individual investor. But they still invest in products that fail.

High-tech shams are common: It’s easier to set up a company and sell stock to investors than to perfect a technological breakthrough. Be especially wary when new technology stocks splurge on elaborate web sites and glossy investor brochures.

Bonus: 4 ways to mitigate the risk of hot growth stocks in the tech industry

Diversify: The high-tech sector has more than its share of winners and duds. So invest carefully and buy more than one. Gains on your winners should overwhelm any losses you have.

Focus on up-and-coming technologies: To do this, you need to know how technology is changing. For instance, the immense popularity of wireless devices, like the iPhone and tablet computers has stepped up demand for faster, more reliable wireless networks.

Buy multi-product companies: Technological advances come in spurts, and they leapfrog each other. Focus on technology stocks that have a number of existing or soon-to-be-released products, and avoid one-hit wonders.

Look for earnings: A perpetual money loser will eventually go broke, no matter how impressive its technology. But if it makes even a little money, it can stay in business and perhaps reap the bonanza of a new product.

Make It 5% of your portfolio at the most

Do examine things carefully, but don’t expect perfection. If one of these hot growth stocks seems to check out reasonably well, you may want to take a chance and add the stock to your portfolio. Ordinarily, we’d limit any one initial purchase to 5% or less.

Even if you go beyond our 5% limit, it’s still a good idea to keep your portfolio well-diversified across most if not all of the five main economic sectors, despite any oversize holding in any one stock or sector. That’s especially so if the hot growth stock is in either of the two most volatile sectors, Manufacturing & Industry or Resources & Commodities.

After that, you need to monitor the stock much more closely than your other holdings, because of the speculative nature of your investment. You’ll need to make a lot of difficult sell-or-hold decisions as the 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 couple 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—and that’s especially true of hot growth stocks.

Have you ever been given a tip about a hot growth stock investment that you decided to follow-up? Did you get it from a friend or acquaintance, or from a professional investment advisor? Was there one outstanding reason that made you decide to invest? Was the stock a winner or a loser? Share your experience with us in the comments.