Don’t catch a falling knife
One of the most common mistakes inexperienced investors make is trying to “catch a falling knife.” This is the phrase used to describe the habit of buying stocks that are in “free fall”, and it is a bad strategy, although common among new investors. Unfortunately, it is a common practice even among old and experienced investors. I’ve even been a victim of it myself.
Remember, there are two main approaches to investing: fundamental analysis and technical analysis. We typically fall into the fundamental camp, as we evaluate stocks based on their valuations, rather than primarily looking at short-term price movements. We took this direction because we believe it provides the greatest potential for long-term success.
However, a resolute view of only the fundamentals of an investment can limit an investor’s gains and lead to some unsavory positions. This is because there are real limitations to buying a stock as it falls. You can buy a stock that appears to be of great value at $10, only to see it drop to $5. Sure, if the stock goes back up to $20, you may have done “right” to buy at $10, but you could argue that it wasn’t “good enough”. Buying at 5 would have yielded a 300% return, while you settled for only 100%. Also, if you were convinced that $10 is a reasonable price, you could have saved time by buying it on the way back instead of on the way down.
It’s quite simple: buying a stock that is in the middle of autumn is not a pleasant experience, and it is not difficult to come up with a variety of other strategies that would bring happy results.
Still, we shouldn’t avoid every stock that has fallen. In fact, studies have shown that investors who buy stocks that have fallen hard tend to outperform the market on a regular basis. In fact, such a bottom fishing strategy can provide one of the best levels of performance of all strategy sets. Missing out on these opportunities can be costly.
The decision then is not whether to buy “fallen angels”, but WHEN. This is where a little technical analysis skill comes in handy. While technical tools can’t really tell you which stocks to buy (unless you’re willing to buy any piece of junk that has a good price push), it can lead us to a better understanding of timing. Once we have selected a good investment based on the fundamentals, it is time to decide when to put the money.
A good first step is to watch for a positive move with good volume before committing. As long as the stock is falling, there is a good chance that you can get it at a better price. It’s best to wait a few days (or weeks) to make sure your purchase happens at the right time. There is no advantage to buying before the time is right, even if the stock choice is ideal. This is where patience is a virtue. Don’t try to catch the falling knives, but be sure to pick them up after they hit the ground.
By: Scott Pearson
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