12/6/2011 12:04 PM ET|
3 simple rules for buying stocks
Keeping a level head is essential if you're going to succeed in the stock market. These tips can help you avoid common mistakes.
Even amid high-frequency trading and politically driven markets, basic money-management techniques should never change. No one is right all of the time; what matters is how you invest, not what you invest in. Disciplined investing transcends bull and bear markets alike.
Each investor must develop a disciplined approach to timing and position size that suits his temperament and goals. When buying any stock, exchange-traded fund or mutual fund, I stick to these three simple rules:
Don't wait for a pullback
When taking a position in a stock -- long or short -- we're foolishly conditioned to want a bargain. So with XYZ at $19.85, for example, we may put off buying shares until we can get them under $19.50, a drop that may never come. If you actually believe shares are headed for $25, why quibble?
So while at first it seems counterintuitive to buy the stock at the current price, if the anticipated "dip" does come, it's more likely a bearish, not a bullish, sign. We fool ourselves into thinking a strong stock will cease its advance only long enough to drop to our ideal purchase price before reversing and heading to new highs.
Set stop limits, not price targets
When buying a stock, we often imagine how high it might rise while rarely considering how far it might fall. Because we have a bullish bias, XYZ seems like $25 in waiting.
Indeed, back in the summer of 2007 few might have imagined that American International Group (AIG, news), Ford Motor (F, news) and Citigroup (C, news) would all approach $1 a share in less than two years. Yet, as I've written before, it's not uncommon that up to one-half of one's trades end up as losses, meaning our inclination should be toward loss limits, not price targets.
Even in cases where I'm unabashedly bullish, I plan for the worst and hope to end up surprised. To that end, every investment one makes should immediately be followed with a stop-loss limit between 13% and 20% below your initial purchase price. Price targets should be skipped entirely.
There are no "tops" in a bull market. If a stock continues to climb and does not grow to dominate your portfolio, it should be kept and not traded away.
Don't create your own head games
We can't control the markets, only our exposure to them. And because XYZ is going to rise or fall regardless of how much we discuss, talk, blog or opine about it, a sound rule of thumb is to keep such distractions to a minimum.
Talk about politics, sports or the economy with others, but beyond your partner and financial adviser, stew over your holdings alone. Simply put, it unnecessarily raises the stakes. As I've often pointed out, investing requires objectivity, not a "gut feeling."
The more you think about trades or talk about them, the more likely you are to feel committed to hold on to them and be proved right; emotion is influencing decisions, not the price action of the securities themselves.
Beyond the tax man, your portfolio is yours and yours alone. For a clear and level head when navigating the markets, keep it that way.
VIDEO ON MSN MONEY
Lord. Who writes this stuff? MSN must institute mandatory random drug and alcohol testing of all employees.
.....and if was always 75 degrees, sunny, birds singing, no wars, no bad people in the world, the lawn was always mowed, I never get fat, old or wrinkled, then that would be great too. :) Point is, you can't "average" 1-2% a month with certainty any more than you can win a $250 M lottery with certainty.
It is interesting that a Jim Cramer video clip was inserted into this article when the three rules are exactly opposite what Jim Cramer believes.
1. "Don't wait for a pullback". What? Every stock has volatility. Even the ones that are going up occasionally pull back. All of them do. Why not buy them a little cheaper? If a stock takes off without you because you never got a pull back, it's not the end of the world. You can't get'em all. Catch the next one. Or better yet, take a small initial position and buy more on any pull back. In the worst case, you will get no pull back and you will not have as much invested as you wanted. That is a high quality problem to have.
2. "Set stop limits, not price targets". Stop loss limits will not always protect you. When your stop loss is triggered, your order becomes a market order, executing for whatever price your broker can find. For this reason, Cramer is opposed to stop loss orders. If you are going to sell, tell your broker how much you want to sell it for. A lot of people lost a lot of money in the flash crash. By the time their order was executed, the market price was down 40% or 50%. Then two hours later, it was back up to where it was supposed to be, and small retail investor is wondering who stole his money. If you use a stop loss limit order instead of a stop loss order, you can at least set the minimum price you are willing to accept. If the price drops too fast, the order won't be executed ad you will still own the stock. This would have saved you from the flash crash, but may not have protected you if you owned RIG the day of the Mocondo oil spill. By the way, Bill O'Neill of IBD is a mathemetician who has studied the subject for years. He recommends you always sell if the price drops to 7% or 8% below what you paid, not 13% to 20%. Keep your losses small and let your winners run.
3."Don't create your own head games". What? Don't discuss your investments with other investors? That's ridiculous. Study your companies. Know what you own. Listen to both bear and bull arguments. Gather as much info as possible and make an informed decision. And admit when you were wrong (and you will be wrong frequently) and close the position. If you do not have the time and inclination to devote to what Cramer calls "homework", put your money in an index S&P 500 fund and an index bond fund. Check on them every three months and then go play golf.
Watch this info on stop losses. it is wise to put one in but a 20% stop loss may not help.
A stock could close one day at $20. Bad news after hours and the next morning the stock opens at $10. All stop losses would not be filled as the 20% drop never happened during trading hours.
I have been investing for over 25 years and have had this happen a number of times, so stop losses don't always reduce risk.
One tip- if you can average just 1-2% per month you would have an awesome annual return. 1-2% with compounding over time will provide a very nice nest egg.
Good point Secundus. I'll have to rethink this. Over a cocktail.
But now a days it such a short wait until the next pullback. Stop losses can get run right over. I rather look often. I've got some buys in on quality stocks that I been waiting on for awhile and I bet I get them and the market will swoosh right on by and I'll be moaning that I coulda got them lower, but then, after Obozo is gone the market will come back up and I'll be happy again.
I've got different rules and I'm not telling, but they are flexible, often amended and frequently violated..
Just buy diversified.
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