3 Tips to Help You Buy a Stock the Right Way

Source: Thinkstock

Source: Thinkstock

As an investor you need to figure out three things before making an actual investment:

  1. You need to figure out which stock to buy.
  2. You need to figure out when to buy it.
  3. You need to figure out when to sell it.

Most investors focus on just the first point. An investor will decide that he or she likes a particular stock and just buy it. On the one hand this strategy makes sense. If you analyze a stock that trades for $40/share and decide that it is worth $60/share, then it should follow that you should decide how much you want to invest and simply buy the stock.

But this is a lousy strategy. The reason that it is a lousy strategy is that efficient market theory—or the theory that market prices reflect a perfectly rational analysis of an asset’s valuation—is nonsense. After all if the stock you are analyzing is worth $60/share then why is it trading at $40/share? But from this it follows that it is possible for the stock to trade down to $35/share, or even down to $20/share while still being worth $60/share. In short to simply buy an asset because it is undervalued is to ignore the character of markets, and this can cost you money.

With that being the case once you have picked out a stock and an amount of money that you wish to invest in it you should follow a disciplined buying strategy. While there is no single correct approach, here are some guidelines that will help you formulate a strategy that works for you.

1. Take advantage of naturally occurring volatility.

Markets are volatile: Prices are constantly fluctuating. Therefore, as an investor if you recognize this fact you can improve your investment performance. So let’s revisit the above example. If the stock you are interested in buying trades at $40/share, then while you may believe that it is worth $60/share, there’s a pretty good chance that market volatility will cause the stock to trade a little bit lower than $40/share before it begins its ascent to $60/share. So rather than buying it at $40/share, it makes sense to try to get it a little bit cheaper—say at $38/share.

The upside to this is that you’ll be able to buy 5.3 percent more stock than you would have bought had you simply invested at $40/share. But there is a downside, namely there is a chance that the stock will not trade as low as $38/share. As an investor you need to do a cost/benefit analysis of the situation and come up with a solution that fits your investing strategy. If you are really eager to own the stock, and there aren’t a lot of other stocks out there that you are interested in buying then maybe you’ll want to wait for $39/share. However if there are a lot of different stocks on your radar you might want to wait for a larger pullback to $36/share, for instance. You are less likely to get the stock in the latter case, which is okay because you can always buy one of the other stocks that you like.

Ultimately it is a matter of personal preference, but generally speaking you will do yourself a great deal of good if you use naturally occurring market volatility to your advantage.

2. Don’t invest your entire position at once.

Chances are you’re not going to be able to pick the bottom in a stock. Even if you think it can trade at a substantially higher price there is a very good chance that it will trade lower before it trades at that substantially higher price. So you should be humble and accept that there is a very good chance that you won’t pick the bottom prior to acting. What this means is investing in tranches. If, for instance, you want to invest $5,000 in the aforementioned $40/share stock you might first start out by buying $1,500 worth at $38/share. The worst thing that can happen—assuming you are right that the stock is worth $60/share—is that the stock rises and you don’t get your position. If the $38/share level is hit then either the stock goes up and you don’t get to take your fully desired position, or the stock goes down, and you can then buy more—say anther $1,000 at $35/share. If you don’t get the opportunity then it’s not so bad—you still have a partial position. And if the stock goes down some more then you get to buy it at a lower price, which means that if you are right then you make more money.

3. Sell when your price target is reached.

Selling is very difficult, especially if you have a profit. Profits are psychologically satisfying because they are tangible evidence of our own intellect. But if you bought our example stock and it trades up to $60, then unless the fundamental valuation has increased you have to sell your stock at $60/share. I know that there are some wise investors out there who buy and hold forever, but this strategy assumes that the world remains stagnant, and we know this isn’t true.

Take Warren Buffett, for instance. He looked like a genius for having purchased a lot of Coca Cola (NYSE:KO) when it was cheap. But his “buy and hold forever” strategy proved to be a miserable failure. The stock peaked out in 1998 and it still hasn’t surpassed that level, and while it has paid some dividends and while it has grown into its valuation, the fact remains that the correct strategy was to sell the stock when it was overvalued.

Disclosure: Ben Kramer-Miller has no positions in any of the stocks mentioned in this article.

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