Well that’s more like it.
After days of what we can only describe as dull market action, yesterday the Australian market took a 1.4% tumble.
We won’t say we’re glad stocks fell. We hate it when investment pros say they’re glad stocks fell.
No one likes it when stocks fall. We want stocks to go up all the time…just like house prices go up all the time [wink].
But when stocks fall, it can create an opportunity. Because right now, even though the market is full of fear, we still say this is a great time to buy stocks rather than sell. In fact, this market action is exactly why we advise readers of our paid advisory services to remain patient and disciplined when buying stocks.
Because it’s a day like yesterday that rewards investors for their patience…
As we’ve explained over the past few weeks (without much gratitude for pointing this out, based on some of the feedback we’ve received) many investors make a lot of basic mistakes when they buy and sell stocks.
One of the biggest mistakes is to be reactionary to prevailing market events.
A classic example of this was the steep market decline from the end of May through to early July.
At that time we felt like the only person in the room who didn’t panic when stock prices began a 10% drop. The front pages of the daily papers screamed about the billions wiped of the market’s value.
There were wails about rising bond yields and the inevitable collapse of…well, if you listened to them, everything.
And yet the market didn’t collapse. In fact, as we explained at the time, that period looked to be the last time this year that you would get to buy stocks that cheap.
Resource investing guru Rick Rule pointed out in his recent presentation that investors tend to make irrational decisions when they buy stocks. They jump on the band wagon and buy stocks at or near the top of the market.
And they panic and run away from the market when it’s at or near the bottom.
Now, we won’t give those investors too hard a time. We’ll admit that it’s not always easy to tell when the market is high or low. You only know for certain when you look back at the market.
At that point it’s easy to say, ‘I should have bought then.’ That’s hindsight investing. You won’t be surprised to learn that hindsight investors bag winning trades every time!
But because you can’t be a hindsight investor in the real market, it means you have to take a cautious and reasoned approach when buying and selling stocks.
That’s why in every issue of Australian Small-Cap Investigator we advise readers to stick to what we call a ‘buy-up-to’ limit. It’s a strategy you can use too. It’s a simple but effective way to make sure that you don’t pay more than you should for a stock.
It’s a strategy you can use in unison with other strategies such as ‘scaling in’ to a position (we won’t elaborate on that today; we’ve discussed ‘scaling in’ in the past).
The temptation when buying into a rising market is to think you’ll miss out if you don’t buy in right now, regardless of the price.
The temptation becomes even greater if you stop and pause and then see that the price has clicked higher again. You think, ‘Man, if I hadn’t messed around I would already be $500 richer.’
So you start entering your order and by the time you click ‘buy’ the stock has clicked higher again. That’s another $500 you could have made if only you had acted quicker.
You buy the stock, and then the inevitable happens – the price falls. Before you know it, you’re down $1,000. If only you had exercised a bit of patience and waited.
Of course, that doesn’t happen every time. Sometimes a stock is on such a tear that you buy in and it just doesn’t stop going up. But you can’t guarantee that every time. In fact, we’d say that by the laws of averages for every time that happens you’ll buy another stock that keeps going down after you buy it.
This is where a ‘buy-up-to’ price is important. In each issue of Australian Small-Cap Investigator we’ll explain to readers that they shouldn’t pay more than a certain price for a stock.
For instance, if a stock is trading at 20 cents we may advise investors not to pay more than 23 cents for it. This ensures investors don’t overpay for a stock.
Overpaying for a stock is a big no-no in investing, especially with small-cap stocks.
When a stock is 20 cents and we’re forecasting a potential rise to 80 cents, some investors can become over-excited. They may think, ‘Hang on, if it’s going to 80 cents then why not pay 30 cents or 40 cents? I’ll still more than double my money.’
The reason you shouldn’t do that is simple. First, if you buy a stock at 23 cents and it goes to 80 cents then you’ll make a 248% return. But if you buy a stock at 40 cents and it goes to 80 cents, you’ll only make a 100% return.
That’s a big difference.
But secondly, small-cap investing is all about momentum and expectations. It may sound odd, but if a small-cap stock takes off too quickly the company may struggle to satisfy investor expectations.
Even though the news flow may be the same regardless of the stock price, if investors buy in hoping for quick gains only to realise the gains may take longer than they expected, those investors will soon become dissatisfied and can cause a lot of selling pressure.
Just look at any resource or tech stock that has taken off in a flurry of excitement, only to quickly fall again.
This is why we always publish a maximum ‘buy-up-to’ price. It’s not that we’re against stock prices taking off, it’s just that we’d rather our readers get into the stock at a good price before the excitement, rather than piling in afterwards and being disappointed by the outcome.
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