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Timing Your Stock Purchases
| Avoiding Lead Bricks Ever buy a stock only to watch it plummet immediately afterwards? I think that most of us have. One of my most recent blunders was a uranium exploration company that was trading for around $1. "What a deal!" I thought as I hit the buy button. What do you suppose happened that same week? Imagine a lead brick being tossed from a third story balcony. Not one of my better trades. This brings to mind a quote by the great Richard Russell of the Dow Theory Letters: |
by Daniel R., Homemade Investors
Tuesday, May 13th, 2008
Tuesday, May 13th, 2008
| But before we get into the details, let's look at some case studies. ****************************************** Case Study 1: Greed and Fear Question: Which of the following two scenarios do you think present a better environment to buy a stock you plan on holding long-term? Scenario A: A Negative Environment Business News: "After several consecutive weeks of selling, all but the most tenacious investors have thrown in the towel." Columnist: "This is extremely bearish action. Although stocks are oversold, investors should take defensive action in case broad market indexes crash major supports." Water Cooler Guy: "The past few weeks have been brutal! Yesterday I called my broker and told him to sell everything!" Scenario B: A Positive Environment Headline: "Summer of the Bulls?: Better-than-expected gains exceed analysts' best estimates." Newsletter: "I could go on, but let me sum up in three words: Buy, Buy Buy!" Stock Broker: "Personally, I think you should double your holdings in [your stock's name here]. It's had a terrific run so far this year and the smart money has been piling in like crazy!" ****************************************** So which of the above scenarios provides a better environment to buy a stock? Initially, it might make sense to buy when most people are optimistic. After all, markets tend to go up when people are optimistic, right? Let's get the opinion of Warren Buffett, an investor who's smarter than most of us: "If [investors] insist on trying to time their participation in [stocks], they should try to be fearful when others are greedy and greedy only when others are fearful."2 What do you suppose happens when an investor ignores his or her emotions, and does the opposite of the crowd? Let's look at an example in the next case study. ****************************************** Case Study 2: Buying When People Are Fearful On December 20th 2007, two analysts made the following comments regarding the much beaten down gold stock sector: "People buy because of greed and sell because of fear. They should do it the other way around. [...] Everyone is terrified of buying right now [...] That means it's time to buy... Correction's over... Back in the pool."3 - Bob Moriarty "There is an uncanny silence across the sector – gloom and despondency fill the air. Incoming Emails have dried up, the all important MSI, the Maund Subscriber Index [to his newsletter], has dropped back to a cyclical low that in the past has always signaled either a low, or a point very close to it. [...] The right tactic here is to buy..."4 - Clive Maund Question: Which of these two analysts followed Warren Buffett's advice? ****************************************** Both analysts heeded Buffett's advice to buy when investors are fearful. In fact, I remember December 2007 well, when these buy recommendations were issued. Gold stocks seemed to have bottomed after a particularly nasty decline and didn't seem to be going anywhere. Relatively few shares were being traded. It was as though everyone had lost interest in the sector. I certainly couldn't blame them since few people were happy with the sector's recent performance. Nonetheless, a few bold investors heeded the analysts' advice and bought precious metal stocks at this time, myself included. And how do you suppose we did? Take a look at the following chart, which features a common index of gold stocks: That's a 25% return in about 4 weeks! Although these opportunities don't come along every day, diligent and patient investors stumble upon similar opportunities at least a few times a year. Not all such instances turn out to be good investments (obviously), but keep in mind that "stop losses" can be employed to protect you. Stop losses automatically sell your shares if the price drops below your chosen stop price. If the above index were a stock, for example, an investor might have bought shares at the $380 mark, and then placed a stop loss order just under the recent lows (let's say $369). In this case, the investor would have risked a 3% loss to make a 25% gain! So why is it good to buy a stock when shareholders are the most distraught? Here are some reasons: (1) Stocks are selling at a discount - Panicking sellers often oversell a stock, which can provide a favorable entry point. In other words, it's better to buy a stock when it's cheap. (2) A turnaround may be imminent – Plummeting stocks often find a price bottom just after investor sentiment is at its very lowest (which happened in the previous example). There's a couple of reasons for this. First, if investor sentiment is truly awful, then everyone who is going to sell has probably already sold. In other words, selling slows. Second, bargain hunters start buying. Once buyer volume begins to overtake selling volume, then the decline is over and a new uptrend may not be far off. Using Charts To Time Your Purchases How can one quantify investor sentiment and determine if a stock, commodity, or index is selling at a discount? There are several ways to do this, but the simplest way is by looking at stock charts! The analysis of stock charts is called Technical Analysis. Free charts and indicators are available at www.StockCharts.com. Chart Indicators are tools that investors use in connection with charts to help them analyze and understand what a chart is saying. Each chart generated at www.StockCharts.com automatically provides some useful indicators above and below each chart. These indicators can help you decide when it's a good time to buy a stock, commodity, or index. Here's an explanation of two particularly useful indicators: RSI (above the chart): Shows when a stock/index is overbought or oversold. Traders usually buy when the RSI is oversold (at or below the 30 line) and hold or sell when the RSI is overbought (at or above the 70 line). Notice on the chart that if you bought when the RSI touched or dipped below the RSI, you would have bought at a better price than if you averaged your purchase over time. [Click here to learn more about RSI.] MACD (below the chart): Shows when a stock is changing direction. Traders buy when black crosses above red, and sell when black crosses below red. Ideally, if the RSI says oversold or overbought, you may want to seek confirmation by a MACD crossover since a stock often drops farther or rises higher in spite of the RSI's oversold/overbought signal. In other words, a stock's reversal is not confirmed until we see the black line cross above the red and both begin to move up. The MACD also confirms if a stock or index is oversold or overbought. The lower the black and red lines are compared to where they've been previously, the more oversold the stock is. The higher the lines are compared to where they've been previously, the more overbought the stock is. Sometimes a stock will make a significant move before the MACD crossover occurs, so investors will often buy an oversold stock when the MACD appears to be getting ready to cross over. [Click here to learn more about MACD.] Important Points to Ponder:
******************************************* ****************************************** To sign up for our FREE EMAIL NEWSLETTER, visit our main page at http://www.HomemadeInvestors.com. Disclaimer: Homemade Investors is published by Homemade Investors LLC. The information contained in this article does not constitute personal investment advice and is not designed to meet the personal financial needs of any individual. Investors should seek advice from a qualified investment advisor before entering into any transaction. The information contained in this article is deemed reliable but is not guaranteed. The information and opinions contained in this article are subject to change without notice, and there is no obligation to update such. To republish this article, visit http://www.HomemadeInvestors.com/reprint for guidelines. © 2008 Homemade Investors LLC. All rights reserved. |
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| "Timing is the most difficult thing to master in investing. [...] Almost any item, bought at the right time, will produce profits. Most people lose money because they fail in timing their purchases, and they fail in timing their sales."1 ** So what's the average investor to do? With a little knowledge and a few simple tools, it's possible to time your stock (or commodity) purchases in a way that maximizes your profit potential and greatly decreases your chances of having "lead brick" experience. How? By buying at a discount, of course! |
| An inspiring image of some lead bricks |
| So when are investors greedy and when are they fearful? Investors often get greedy when significant gains have already been made. This "greed" causes most investors to buy when prices are relatively high, because they want to get in on the action! On the other hand, investors are usually fearful when significant losses have already taken place. Fearful investors tend to sell (and refrain from buying) when prices are relatively low. In short, fear and greed convince average investors to buy high and sell low. How's that for a strategy? Well, that's precisely the strategy you adopt when you follow your emotions and buy and sell with the crowds. |
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Avoid stocks that are in long-term downtrends, like the
one on the chart above. Indicators won't help you much
when the long-term trend is down.
one on the chart above. Indicators won't help you much
when the long-term trend is down.