Effective Advice For A New Generation of Investors

CATCHING A FALLING KNIFE

One of the most common mistakes made by inexperienced investors is trying to "catch a falling knife". This is a habit, common among new investors, of buying stocks that are in "freefall", and it's a bad idea for an investment strategy. Unfortunately, it's common even among old and experienced investors. I have to admit that I've even made that mistake myself.

There are two primary approaches to investing: fundamental analysis, and technical analysis. At my firm, 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.

Just looking at 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. You may purchase a stock that looks great at $10, only to see it fall to $5. If the stock rises again to $20, you may have been "right" to buy at $10, but maybe you weren't "right enough". Buying at $5 would have yielded a 300% return, while you settled for only 100%. Furthermore, if you thought that $10 was a reasonable price, you might have saved time by buying it on the way back up instead of on the way down.

Let's face it: 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 will bring better results.

Still, we shouldn't avoid all stocks that have dropped. In fact, studies show that investors who buy stocks that have fallen hard, tend to outperform the market on a regular basis. In fact, this "bottom-fishing" strategy can provide one of the best performance levels of all, but missing out on these opportunities can be costly.

The decision then is not whether to buy "fallen angels", but when. This is where a bit of technical analysis skill comes in handy. Unless you're willing to buy any piece of junk that happens to have good price momentum, technical tools can't really tell you which stocks to buy. But they can lead us to a better understanding of timing. Once you select a good investment based on fundamentals, it is time to decide when to put the money down. A good first step: 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 right. There's no advantage to buying before the time is right, even if the choice of stock is ideal. In this case, patience really is a virtue.

Remember: don't try to catch a falling knife - pick it up after it hits the floor!

R. Scott Pearson is an investment advisor, writer, editor, instructor, and business leader. As President and Chief Investment Officer of Value View Financial Corp., he offers investment management services to a wide variety of clients. His own newsletter, Investor's Value View, is distributed worldwide and provides general money tips and investment advice to readers both internationally, and in the U.S.

Prior to founding Value View, Scott edited the Pearson Investment Letter for eight years, and served as a Registered Investment Advisor for Pearson Capital Management. 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 newspapers, covering a wide range of topics from investments and IRAs to mortgages and credit issues.