Catching a Falling Knife


Wall Street has a lot of sayings developed by traders who learned one lesson or another, usually after losing a great deal of money.  One of the bromides is to “catch a falling knife,” usually used in phrases like “He tried to catch a falling knife with that stock and lost his shirt.”

In stock market parlance, to “catch a falling knife” if to buy a stock that is declining rapidly in price with the hopes of buying the stock at the bottom, thereby getting a good price, from which the stock rebounds sharply, leading to a quick profit.  As would be the case with trying to catch a real falling knife (picture point side down, razor-sharp, rocketing towards your foot) the maneuver is tricky.  If you move too soon, you will be rewarded with a slice in your finger or a point in your palm.  If you move to slowly as the handle whizzes by, you’ll miss the knife entirely.

Buying falling stocks is a form of value investing, in which an investor buys stocks that he believes are undervalued and holds them until he believes they are fairly valued or overvalued.  The general premise is that an undervalued stock will eventually return to its fair value, and that undervalued stocks will do better than overvalued stocks.  Value investing is based on the “buy low, sell high” philosophy.  This strategy has proven itself at various points in the past, although in recent years the momentum investing approach (buy high, sell higher) has actually been more profitable.

 

        

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The trouble with buying declining stocks is that stocks that are falling rapidly in price are usually falling for a reason.  Looking at the current British Petroleum fall, the stock is declining because the clean-up efforts from the oil spill will cost unknown billions of dollars, which in turn will hurt earnings.  There is speculation over whether the dividend will be cut or eliminated, how big the losses will be, and how much will be paid in legal costs and claims resulting from the numerous lawsuits that will no doubt come in the next year or two.  In addition, the actions that the US Government may take and their effect of future profitability are unknown at this point.  Because stock investors hate uncertainty the price will continue to fall. (Even if the news is bad, if you know the numbers you can value a stock.  If there is uncertainty no one knows how to value the stock and therefore are afraid to step in and buy).

The only time to try to catch a falling knife is when the whole market is declining, and then to pick up shares of a stock you have determined to be a good long-term buy and were accumulating anyway.  In this type of situation, good stocks and bad tend to decline, so your great company will fall along with everything else.  When the markets turn around, the great stocks are the first to shoot back up, providing once-in-a-lifetime returns.

To determine if the whole market is declining, rather than just your stock, look at the mid-term charts (maybe 6-month time span) of several stocks.  If they all look about the same, with head and shoulder patterns and then a downward trend, the whole market is falling (the current market is like this).  If only the stock you are interested in is falling, it is best to stay away because there is probably something other know that you don’t (yet).

 

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If you determine that the whole market is falling, the way to catch the knife is to wait for the initial decline to start to slow and flatten out and then buy about 1/3 of the number of shares you will eventually buy.  Then, wait for the rise and hope it is a bear-market, “suckers” rally.  If it is, wait for the stock to decline beyond the previous low and then wait until it begins to flatten again.  Buy the second 1/3 here.  Repeat one more time if the market cooperates and there is a third downturn.  If the stock moves up and crosses the original high (the “head” of the “head and shoulders” pattern) wait for the subsequent low and buy the rest  of the shares because the fall is probably over.

After you are all in, just sit back and wait.  The stock may fall farther, but by buying in stages you lower your cost basis and also are aided psychologically.  As the stock moved to new lows, since you were hoping it would continue to decline, you don’t get the self-doubt that you get when you buy the full position at once and see the price continue to decline.  It is almost impossible to catch the exact bottom, but this way you had three tries.  Eventually the stock should recover and set a new all-time high if you picked the right kind of stock, so whether you got the exact bottom or not won’t really matter.

Happy catching!

Join the conversation and help make this blog more exciting!  Please leave a comment.  Also, if you have an investing question, email  vtsioriginal@yahoo.com or leave the question in a comment.

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.

Should You Invest a Lump Sum All at Once?


There was an interesting article in Money magazine this month about dollar cost averaging.  Typically, this is where you would buy investments at regular intervals, for example putting $500 per month into a mutual fund over a period of several years.  The idea is that then you buy shares both when prices are high and low, buying more shares when they are low (since you’re putting in a fixed amount of money each month).  Buying more shares when prices are lower means that you’ll get a cost basis lower than the average stock price for the period over which you were buying, so even in a flat market you’ll make a small profit.  Dollar cost averaging is a great idea since it 1) does get you a good price and 2) gets you putting away money regularly, which is the secret to becoming financially independent.

What the article was really talking about, however, was whether it was better to invest a lump sum all at once, or invest a portion of the money each period over several periods.  For example, if you got a $1M inheritance or a big lump sum payout from a pension fund, should you invest it all at once or maybe put in $50,000 per month for a couple of  years.  Their conclusion was that it is better to just drop it all in at once.  I’m not sure I agree.

        

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They cited a study by Vanguard that showed that you’d be better off 2/3rds of the time just investing all at once than spreading it out over several periods.  This makes sense since the market goes up about 2/3rds of the time.  Their reasoning for doing so despite what happens the other 1/3rd of the time – when the market declines after you invest – is that if you plan to put 60% in stocks and 40% in bonds, for example, you’re already investing to manage risk.  It therefore makes little sense to hold back cash and go against your investing plan.

The problem I have with this plan is psychology.  It would be devastating for most people to invest the $1 M they’ve gathered up all of their lives in their pension plan and see a 40% loss as we saw in 2008.  It would be even worse to see another event like the market crash of 1929 where 90% of the value was wiped out and it was more than 15 years before people were back to even.  Many people would simply cash out and go into T-bills and bank CDs after suffering through such an event.  As we saw in 2009 and 2010, this is often exactly the wrong thing to do since markets have almost always recovered fully from such events within a year or two (1929 being the exception).  If someone invested just $100,000 of a $1 M lump sum right before the drop, hopefully they would see it as an opportunity and continue to invest in regular increments.  Even in 1929 they would have made out like bandits this way because it is right after large drops that the market is on sale.

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So yes, statistically it is better to invest all at once, but psychologically it is better to wade in slowly. The consequences of dropping a large sum into the market right before a major event are also so severe that a 66% probability of doing better just really isn’t worth the consequences of being wrong.

Even when building up  position in a stock I tend to wade in, rather than taking the plunge all at once.   For example, if I wanted to build up a 1000 share position in BJ’s Restaurants International (a company I usually have a big position in and which I have on now), I wouldn’t typically just put $40,000 into it to buy 1000 shares at $40 even if I had the cash sitting around.  Instead, I might buy 200-300 shares, gather up more cash over the next month or two, then buy another 200-300 shares.  If the stock drops in price, I might use the opportunity to buy more shares at once.  Doing so actually makes drops in share price a good thing that I look forward.

Join the conversation and help make this blog more exciting!  Please leave a comment.  Also, if you have an investing question, email  vtsioriginal@yahoo.com or leave the question in a comment.

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.

Buy on the Rumor, Sell on the News


 There’s an old saying in Wall Street that you should “Buy on the rumor, then sell on the news.”  The meaning is that when you start to hear that something is going on at a company through the rumor mill, you should load up on shares.  When the actual news comes out, however, it is time to sell because the effect of the news is already priced into the price of the shares.  To take advantage of news, you really need to get in before everyone else, which means before the news breaks.
Many novice investors will hear news on a stock and buy or sell shares as a result.  For example, there were likely a lot of people who went out and sold shares of United Airlines the day after the video of the passenger being slammed into the arm rest and then thrown, face bloodied, off of the plane.  I mean, that can’t be good for future sales, right.  The memes that went around the next week with phrases like, “United: Fight or flight, we decide.” and jokes about the United “fight club” don’t build brand loyalty.  Some people probably even sold shares short (which is when you borrow shares and sell them, planning to buy them back later at a lower price and keep the difference).

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The issue is that the news was already out there.  By the time the next morning came around, everyone already knew that United had messed up royally, and the comments by the CEO about the passenger being at fault didn’t help.  So put yourself in the shoes of the other person in the trade – the one who was buying the shares.  Would you have paid the same price you would have the day before, before the incident occurred?  If you wanted to buy the shares at all, you probably would have only been willing if the share price were 10%, 20% or even 30% lower.  You would be expecting a big discount since obviously the next earnings will be a bit lower than they were before.  The shares were not as valuable as they were a day ago.

Let’s use another example not related to the stock market.  Let’s say that you own a car that is worth around $25,000  and you accidentally drive it into a lake.  Let’s say that the fact you drove it into the lake makes the news and everyone knows about it.  Could you expect to then sell that car for $25,000 with everyone knowing that it was driven into a lake and probably fouled the engine and everything else?  The price would drop instantly the moment the news got out.  Someone might offer you a few hundred dollars, either to use the parts or with the plan to fix it up. Just because it was worth $25,000 before the event doesn’t mean you’ll be able to sell it for $25,000 after the news breaks.

                                           

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It is exactly the same thing with stocks.  There is something called “the efficient market theory,” which says everything known about companies is instantly priced into the price of their stocks.  This means it is pointless to try to buy and sell stocks based on the news that comes out because the stock is already priced to take that news into account.  Everybody knows the car has been in the lake.  The best you’ll get is a couple of hundred dollars.  It doesn’t matter how much it was worth the days before or how much you still owe on the car.   It also doesn’t matter how much you need to buy another car.

For this reason this blog will never recommend trying to trade stocks, where you buy one day and then plan to sell a few days, weeks, or months down the road for a profit.  All of the news you hear is already priced into the stock price.  Everyone else has already looked at the same charts you have and sees the same trends.  Everyone else knows that the company is coming out with a new product, or that product A is selling well, or that Baby Boomers are retiring.  The stock is already priced correctly for all of that news and anything you’ll see over a periods of weeks to months is just random noise.  You have a fifty-fifty chance of making money.  Investing is putting your odds way into your favor.

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That said, there is a way that you may be able to take advantage of big news that comes out.  Right after the news breaks, people often overreact, especially if it is bad news.  People don’t really know how big the effect of the debacle will have on United’s share price, so they tend to price it considerably lower until the dust settles.  I mean, if you were buying shares, would you buy if you didn’t think you were getting a screaming deal?  You would want a little insurance.

As a result, if you already owned United shares and were looking to add more, or you were planning to buy before the news and still wanted in, you might be able to buy shares right after the news breaks, a little at first, and then a little more if the shares continue lower, and get a really good price.  Often after the dust settles you’ll see a bit of a bounce back.  This won’t make you rich, but might let you get a little better price than you would have otherwise.

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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.

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