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. Even I myself have been a victim of it.
Remember, there are two main approaches to investing: fundamental analysis and technical analysis. We generally fall into the fundamental field, as we evaluate stocks based on their valuations, rather than primarily looking at their short-term price movements. We take this direction because we believe it offers the greatest potential for long-term success.
However, a unified view of just the fundamentals of an investment can limit an investor’s earnings 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 have great value at $ 10, only to see it drop to $ 5. Surely, if the stock rises back to $ 20, you may have been “right” to buy at $ 10, but it could be argued that he was not “right enough.” Buying at 5 would have yielded a 300% return, while you settled for just 100%. Also, if you were convinced that $ 10 is a reasonable price, you may have saved time by buying it on the way back rather than the way down.
It’s quite simple: buying a stock that is in the middle of fall is not a pleasant experience, and it is not difficult to come up with a variety of other strategies that will bring happier results.
Still, we should not avoid all the actions that have fallen. In fact, studies have shown that investors who buy stocks that have fallen a lot tend to outperform the market on a regular basis. In fact, such a bottom fishing strategy can provide one of the best performance levels 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 whatever junk that has a good price boost), it can lead to a better understanding of time. Once we have selected a good investment based on the fundamentals, it is time to decide when to deposit the money.
A good first step is to observe a positive move at good volume before committing. Whenever stocks go down, chances are you’ll get them at a better price. It’s best to wait a few days (or weeks) to make sure your purchase goes through 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 falling knives, but be sure to pick them up after they hit the ground.
By: Scott Pearson
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