One of the most common mistakes made by inexperienced investors is trying to “catch a falling knife”. This is a phrase used to describe the habit of buying stocks that are in “free fall” and is a bad strategy, although common among new investors. Unfortunately, this is a common practice even among old and experienced investors. I even became the prey of it myself.
Remember, there are two basic approaches to investing: thorough analysis and technical analysis. We mostly fall into the underlying camp because we value stocks based on their estimates, rather than primarily looking at their short-term price movements. We take this direction because we believe it provides the greatest potential for long-term success.
An unanimous look only at the basics of investing, however, can limit investor profits and lead to some awkward positions. This is because there are real restrictions on buying stocks as they fall. A stock that seems of excellent value can be bought for $ 10 only when it drops to $ 5. Sure, if the stock rises to $ 20 again, you may have been right when you bought for $ 10, but someone might argue that you weren’t “right enough”. Buying at price 5 would bring a return of 300%, while you would be satisfied with only 100%. Furthermore, if you were convinced that $ 10 was a reasonable price, you might save time by buying them on the way up instead of on the way down.
It’s very simple – buying stocks that are mid-fall is not a pleasant experience and it’s not hard to come up with a number of other strategies that would bring happier results.
However, we must not avoid all stocks that have fallen. In fact, studies have shown that investors who buy stocks that have fallen hard regularly outperform the market. In fact, such a bottom fishing strategy can provide one of the best levels of performance of all sets of strategies. Missing these opportunities can be costly.
The decision then is not whether to buy “fallen angels,” but WHEN. A little technical analysis skills come in handy here. While technical tools can’t really tell you which stocks to buy (unless you’re willing to buy any piece of junk that happens to have a price boost), it can lead us to a better understanding of the times. Once we’ve chosen a good investment based on the fundamentals, it’s time to decide when we’re going to put the money.
A good first step is to watch for a positive shift at a good volume before you commit. As long as the stock is declining, chances are high that you will get it at a better price. Better wait a few days (or weeks) to make sure your purchase is properly timed. Buying has no advantage before the time comes, even if the stock selection is ideal. Patience is a virtue here. Don’t try to catch knives that fall, but be sure to pick them up after they fall to the floor.
Written by Scott Pearson
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