Different stock picking methods have been popular through the years. Some people try to buy stocks they consider cheap and then sell when they get expensive. Others try to buy stocks that are going up and then step out before they reach a top. The first technique, called value investing investing, is buying low and selling high, the second technique, called momentum investing, is buying high and selling higher.
Today I thought I’d review a few of the strategies and plusses and minuses of each:
Momentum Investing: In momentum investing an individual looks for the hot stocks of the day – those that are going higher and everyone is talking about – and buys them. He then tries to jump ship before it reaches a top and fizzles. This is sometimes called “building castles in the clouds” since the support for these types of stocks is normally fairly weak and eventually they come crashing back to earth. The advantage is that the stocks to buy are fairly obvious – everyone is talking about them, like Apple until recently – and gains are generally made fairly quickly. The disadvantage is that one risks buying into a stock that is overpriced near a top. Usually the hot stocks come crashing down at some point.
Value Investing: In value investing, an investor finds stocks that are cheap relative to their “fair value,” which is calculated based on earnings and other factors. He then buys them while they are cheap and sells them when they start to get overpriced. The advantage is that he is buying low-priced stocks which may not get beaten down as badly during a market fall. The disadvantages are that one need to be very patient since it may take a while for the stock price to turn around and this strategy can be risky because some stocks are beaten down for a reason. Buying companies that go bankrupt is more likely with this strategy.
Buy and Hold: In this strategy, recommended by this blog, stocks are bought in companies that show potential to grow for long periods of time. These stocks are then held regardless of stock price until the fundamentals of the company change or the position becomes too large and a portion must be sold for safety. The advantages are that it is easier to find stocks that will do well over the long-term than it is to find those that will do well over short periods of time and one has a chance of picking a stock that will provide a very large return (in some cases turning a few thousand dollars into hundreds of thousands or even millions of dollars). A disadvantage is that one can also lose a lot of time and potential profits if one chooses a stock that does not do well. Another disadvantage is that when one does make a large profit, much of the value of the stock may be profit, resulting in a lot of taxable income when the stock is sold.
Dollar-Cost Averaging: Rather than a way of picking stocks, this is a way of buying stocks in which an equal dollar amount of a stock is bought at a regular interval – say every month or twice a year. Because an equal amount is purchased, more shares are bought when prices are relatively low than when they are high, resulting in a profit even when the overall price of the stock is fairly flat over the period. This is a good strategy for buy-and-hold investing and generally works best with a stock that has a dividend reinvestment plan that allows purchases of stock since one can therefore avoid most brokerage fees. The disadvantage is keeping track fo your cost basis for taxes. This could be eliminated with the passage of the Fair Tax.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. 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. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.