Investors often use distorted logic when buying stocks:
What goes up must come down?
Stocks that rise steeply in price and make new highs are viewed as expensive and overpriced. Sometimes they are, but you will also find the real winners here - stocks that rise 500 or 1000 per cent. What goes up is more likely to be a winner than stocks that are going down!
What goes down must come back?
Stocks that fall steeply in price, making new lows, are seen as being cheap and showing real value. Sometimes they are, but many stocks never recover. The market has a saying:
Dead cats don't bounce!
Commonly referred to as bottom-fishing, searching for undervalued stocks should be left to the experts: it requires a lot of research and expertise.
A related strategy is to buy more of a stock if the price falls after your initial purchase: if it was a good buy at the higher price it must be a real bargain now. What often follows is that the stock keeps falling ...... disappearing from the radar screens.
No-one has put it better than Jesse Livermore in Edwin Lefevre's book Reminiscences of a Stock Operator
Let him buy one-fifth of his full line. If that does not show him a profit he must not increase his holdings because he has obviously begun wrong; he is wrong temporarily and there is no profit in being wrong at any time.
Tips and Rumors
The quality of stock market tips is generally poor. Investors often become emotionally attached to the stocks that they hold and are not always objective about their prospects. They talk their stocks up, more out of hope than conviction.
Use Stock Screens:
- Search for stocks making New Highs; or
- Rank stocks using Relative Performance over the last 12 months. Select the top 10 per cent for further study.
Chart the relative performance of the stock over 3 years, using the Price Ratio indicator. The indicator should be well above zero and still rising.
These are bottom-swimmers that have started to rise to the surface. Often they are previous darlings of the market that have lost direction and fallen from favor.
- Look for new management, or a major restructuring, and one or two quarters
of exceptionally strong earnings growth.
- Compare earnings forecasts to the current Price/Earnings ratio: expected
growth must be comfortably higher than the P/E ratio.
- Chart the relative performance of the stock over 3 years, using the Price Ratio indicator. The indicator should have returned to above zero and be rising steeply.
Then wait for a breakout signal.
Average up - not down
After your initial purchase, only buy more of a stock if your existing holding shows a profit.
The tape never lies
Pay scant attention to tips or rumors. Likewise to the daily press and television media who seem to call the direction of the market on an hourly basis. Avoid the information overload and place your trust in the tape: actual price movements are the most objective information on what is actually happening in the market.
Focus on the time frame that you are trading and avoid trying to catch the short-term fluctuations.