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10 don'ts for smart stock market investing

April 23, 2009 18:23 IST
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This is a great check list of 10 habits, impulses and tendencies you steer clear of in order to keep your investments healthy.

1. Don't be arrogant

The market teaches humility and that is how you must approach it. As soon as you believe you know why the market acts the way it does, you will be proven wrong. Arrogance can kill a portfolio. You must be able to admit defeat and preserve enough capital to fight again.

Following point and figure charts, which depict the battle between supply and demand, helps keep you out of the 'I know why' attitude of investing.

2. Don't wait until you feel comfortable to buy when a sector reverses up

Falling into the waiting trap is a great way to ensure that you buy the stock at a higher price. When sectors reverse up from oversold levels, it is often when the news is the most dire.

Conventional wisdom would suggest this is the last place in the world you would want to invest. Buying at this time is gut wrenching, but to be successful you must act with complete confidence.

As the sector moves higher, the comfort level increases. If you use comfort level as your guidance, however, you will for sure leave a lot of money on the table, or worse, buy as the sector peaks.

3. Don't be afraid to buy strong stocks

Don't avoid stocks just because they have gone up. Doing so will keep you out of the long-term winners. In the United States, for example, this mentality would have kept you out of General Electric, which was up 188 per cent between January 1995 and December 1997 only to see it rally another 96 per cent by the end of 2000. It also would have kept you out of Cisco, which was up 376 per cent between January 1995 and December 1997, and then it moved up another 312 per cent by the end of 2000. These are only two examples, but there are many others.

More important than how much the stock is up is its supply and demand relationship. By evaluating the point and figure chart, you can gain insight into this relationship and whether or not the stock is likely to move higher. Stocks that double can easily double again. Don't miss out on these great opportunities.

4. Don't sell a stock simply because it has gone up

Doing this cuts profits short. Buying a stock right is only half the battle. You have to be able to sell it right to win the war. Just because a stock has rallied 30 per cent or 50 per cent, don't be tempted to take your trade off for that reason alone.

Consider trimming the position and leave part on the table to continue in the uptrend. Let profits run.

5. Don't buy stocks in extended sectors because 'it's different this time'

On the surface, the stock market appears different all the time. The leadership changes: in come new stocks into the Nifty 50, and then out they go. Small-cap stocks outperform for a while, then it's back to the large caps.

However, the underlying forces that drive the stock market are always the same. They are true and time-tested and do not change. They are supply and demand. That's why buying sectors that are extended (overbought) will not be different this time.

6. Don't try to bottom fish a stock in a downtrend

'The trend is your friend' is a true statement. So don't go against it without some inkling that the trend has changed.

Bottom fishing a stock in a downtrend is the opposite of being afraid to buy strong stocks. Do not buy a stock just because it fell sharply. You want to buy a stock that is likely to move higher, not one that is not likely to fall further.

At a minimum, wait for the stock to show a sign that demand is back in control and suggesting higher prices. That may be a simple buy signal on the chart or a reversal back to the upside after holding an area of support. Also remember why you initiated the position. Be careful not to let a trade turn into something else.

7. Don't buy a stock simply because it is a 'good value'

These days, value is in the eyes of the holder, and therefore it is a subjective term at best. If a stock has become a good value, ask why. This is important, because a stock can stay a good value by not moving for the next decade, or worse, become a better value by dropping another 20 per cent.

The true value of a stock is determined by its capital appreciation potential, not numbers on a balance sheet. The basis for capital appreciation lies in the supply and demand relationship of the stock. Appreciation can occur only if demand grows stronger for the stock and buyers are willing to pay a higher price. Watch the point and figure charts to determine if a stock is likely to move higher in price and become a good value.

8. Don't hold on to losing stocks and hope they come back

Hope is eternal, but your portfolio is not. Holding on to a losing stock is the best way to let your losses run. Combine this mistake with selling a stock that has gone up and you can create a portfolio of dogs.

When buying stocks, there will always be some losers: Count on it. However, how you manage that loss often determines the success or failure of the overall portfolio. Keep losses small so that you have the capital to play again. Hanging on to losing positions, hoping that they will come back, can be deadly.

A $50 stock that is stopped out at $40 is a 20 per cent loss. It's a bad trade, but it is manageable. In order to recoup that loss you would have to make 25 per cent on a $40 stock. What if you held on to that $50 stock, hoping that strong earnings would come in and turn it around, but instead it continued lower to $25?

Finally, you decide to exit, but now it takes a 100 per cent return from a $25 stock just to get back to even. Those results are hard to find, and if you are able to find one, you don't want to waste it on getting back to even

Learn to recognize your losing positions for what they are. If a stock cannot trade above its support line or is not outperforming the averages, find one that is and swap it.

9. Don't pursue perfection

There are two types of mistakes to discuss here. The first is the constant belief that there is a better system out there, and you need to find it.

Using a new system to invest each week will not get you to your goal. You will become good at nothing and moderate to bad at everything. To be good requires that you stay focused, disciplined, and skilled at whatever methodology you choose.

You need to have the strength of conviction in your chosen discipline to learn from mistakes rather than to run away from them and find another methodology. There is no Holy Grail in investing.

The second mistake is to wait for the perfect trade. There is no such thing. If you only buy stocks that have all positive attributes you will maintain a portfolio of cash. Rarely, if ever, do you find a stock that has all the pluses on its side.

Look for the big ones like relative strength, trend, and signal. Also remember that 80 per cent of the cause of price movement in a stock is based on the market and sector. You are better off being approximately right than precisely wrong.

10. Don't do anything based on a magazine cover

Following the hot news that appears on magazine covers is a shortcut to the poor-house. Why should you follow the advice of someone who has just moved from the society pages to the business section?

[Excerpt from Tom Dorseys Trading Tips. Published by Vision Books]

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