Oftentimes we will buy a stock after we hear a compelling story from some analyst or from an executive from the company. They make it seem as if you are guaranteed to make money when you buy a stock. But this simply isn’t so. At best, we can try to put the odds in our favor and even then, it takes a lot of hard work that requires you check your emotions at the door. So before you decide to pull the trigger, ask yourself the following three questions.
1. Who’s selling and why?
One thing that people forget when they are buying a stock is that there is always somebody on the other side of the trade — somebody is selling the stock to you. We often forget this point, and by extension we forget that the person on the other side of the trade has a reason of his/her own for selling. This reason may have nothing to do with the fundamentals of the underlying company.
For instance, the stock may have risen a lot and the investor wants to rebalance his or her portfolio. He or she may also need the cash. But it is also possible that the owner of the stock bought the stock at a lower price in anticipation of the same story that is now prompting you to buy it at a higher price. It may also be a seasoned short-seller who is borrowing stock from his or her broker as a result of extensive research into the aggressive accounting strategies that management relies upon to sucker new investors in at an irrationally high price. While we can never know for sure we should at least take a guess, and more importantly, understand the bear case.