One of the most common mistakes made by inexperienced investors is trying to “catch a falling knife”. This is the phrase used to describe the habit of buying stocks that are in “freefall”, and is a poor strategy, albeit common among new investors. Sadly, it is a common practice even among old and experienced investors. I’ve even fallen prey to it myself.
Remember, there are two primary approaches to investing: fundamental analysis and technical analysis. We generally fall into the fundamental camp, since we evaluate stocks based upon their valuations, rather than looking primarily at their short-term price movements. We take this direction because we believe this provides the greatest potential for long-term success.
A single-minded view of only the fundamentals of an investment, however, can limit an investor’s profits and lead to some unpleasant positions. This is because there are real limitations to buying a stock as it falls. One may purchase a stock that appears to be a great value at $10, only to see it fall to $5. Surely, if the stock rises again to $20, you may have been “right” to buy at $10, but one might argue that you weren’t “right enough”. Buying at 5 would have yielded a 300% return, while you settled for only 100%. Furthermore, if you were convinced that $10 is a reasonable price, you might have saved time by buying it on the way back up instead of on the way down.
It is quite simple – buying a stock that is in mid-fall is not a pleasant experience, and it isn’t difficult to come up with a variety of other strategies that would bring happier outcomes.
Still, we mustn’t avoid all stocks which have dropped. In fact, studies have shown that investors who buy stocks which have fallen hard 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 tad of technical analysis skill comes in handy. While technical tools can’t really tell you which stocks to buy (unless you’re willing to buy any piece of junk that happens to have good price momentum), it can lead us to a better understanding of timing. Once we have selected a good investment based on fundamentals, it is time to decide when to put the money down.
A good first step is to watch for a positive movement on good volume before committing. As long as the stock is dropping, there is a good chance you may get it at a better price. Better to wait a few days (or weeks) to assure your purchase is timed appropriately. There’s no advantage to buying before the time is right, even if the choice of stock is ideal. It is here that patience is a virtue. Don’t try to catch falling knives, but be sure to pick them up after they hit the floor.
About Scott Pearson
President Scott Pearson is an investment advisor, writer, editor, instructor, and business leader. As editor and publisher of Investor’s Value View, a national investment newsletter, he provides general money tips and investment advice to readers, and demonstrates a special knack for locating the up-and-coming stocks in the burgeoning high-tech industries. As President and Chief Investment Officer of Value View Financial Corp., he offers investment management services to a wide variety of clients. Prior to founding Value View, he edited the Pearson Investment Letter for eight years, and served as Registered Investment Advisor for Pearson Capital Management. Many of his newsletter articles and recommendations have been reprinted in other leading investment publications, including Investor’s Intelligence, Bull and Bear and the Dick Davis Digest. In addition, he has written columns and articles of general interest for various Florida newspapers, covering everything from investments and IRA’s to mortgages and credit issues.
He earned his undergraduate degree from Samford University in Birmingham, Alabama, and a Master of Business Administration (MBA) degree from the University of South Florida, where he has also taught classes. Serving as an adjunct instructor at USF (the nations 17th largest university) and at Webster University, he has instructed students in such areas as Finance, Investments, and Money and Banking.
Mr. Pearson has also served as a counselor and educator with Consumer Credit Counseling Service of the Florida Gulfcoast, a non-profit United Way agency, helping individuals learn to work through financial difficulties. As a community service, he continues to offer general financial advice without charge to those who cannot afford professional guidance.