In this post I’ll continue to describe the steps for getting started in investing. This is part of a series of posts on beating the market that starts here:
In the last post I started to describe how a young person — with plenty of time to grow wealth and the time to recover from mistakes — would start investing. Out theoretical investor, Fred, built up a set of positions in three companies he felt had a good chance of growing for the next several years. He did this by buying 100-300 shares at a time as his chosen stocks dipped in price. Finally after a period of time, (which could be a year or more, depending on how much extra income he had to invest), he would reach the point where he would have three significant positions in companies that he believed had good long-term growth prospects. In this post, we’ll follow the same theme and talk about Fred’s next moves.
For each of Fred’s three positions, one of three things could have happened. These are 1) his stock went up in price, 2) his stock went down in price, or 3) his stock stayed at about the same price. Let’s look at how to address each of these three situations:
1) The stock went up in price
Congratulations to Fred. The market saw the good prospects of his chosen company and decided to bid up the price. Note that while the market price will eventually follow the increase in intrinsic value of a stock, which will grow if earnings are growing, there is no reason to believe that it will have any correlation to intrinsic value in the short-term (periods of a few months). There may have been some favorable news that came out about the company, stocks in general may have moved up, or various traders may have been pushing the stock around for random reasons. The fact that the stock increased in price, while nice, therefore means nothing about the correctness of the pick.
If the stock continues to grow in price, such that the value of the holding becomes much larger than that of the other two, Fred should sell off some shares and buy more of the other stocks. Once again, the deciding factor is how much Fred is willing and able to lose — no single position should be greater than this amount. If all three positions have reached this threshold, it is time to start looking for a fourth stock to start buying.
2) The stock went down in price
Just as the stock going up in price was just happenstance, a decline in price is not necessarily significant. For stocks that have gone down, Fred should examine the fundamentals of the company again to see if there is something he missed. Likewise, he should look for any news articles that may explain the decline. If there are any, he should determine if the effects are short-term or cause a change in the fundamentals of the company. As long as the reasons for which he bought the stock remain, he should stay invested.
There is a temptation to buy more shares. This process, called averaging down, is attractive because one feels that by lowering one’s cost basis, one is reducing the loss and one will make more money if the stock increases in price. While this is an attractive option, it is best not to average down once a position of the desired size is obtained. There may be something fundamentally wrong with the stock that was missed and averaging down will just be throwing good money after bad.
3) The stock stayed at the same price
The response to the stock staying at the same price would be the same as that for the stock going down in price. Stay the course unless something else has changed.
In the next post, we’ll continue to follow Fred as he builds up a larger portfolio.
This is one of a series of posts in the category of “Making Market Beating Returns.” See the rest of this series: https://smallivy.wordpress.com/category/making-market-beating-returns/
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.