Don’t Fight the Chart

08/03/2011 7:30 am EST

Focus: STOCKS

Paul Goodwin

Emerging Markets Specialist and Analyst, Cabot Heritage Corporation

It’s easy to get caught up in a compelling story when doing your stock research, but market data is much less likely to lie, writes Paul Goodwin of the Cabot Market Letter.

For the last 18 years, I’ve been leading film discussions at The Music Hall, a wonderful old theater in the heart of downtown Portsmouth, New Hampshire.

Once or twice a month, I do some research on a movie that’s showing there and talk it over with a small group of film enthusiasts after the film has screened. I give a little background on the film—who directed, who wrote it, how it got made, etc.—and we talk it over. The Music Hall supplies the coffee and popcorn.

I realized the other day that the process of familiarizing myself with a movie in preparation for a discussion is a lot like doing research on a stock before buying it.

Like a movie, each stock has a story. Companies are founded to provide particular goods or services, and their business strategies can be all over the map, from modest niche businesses to grandiose, world-changing enterprises.

And it’s often the story that first attracts investors to a stock. There’s nothing like a "can’t-miss" business proposition to fire the imagination.

In the same way that we describe a movie as a comedy, drama, action, or horror flick, stock stories fall into larger categories like growth stocks, value stocks, income stocks, or penny stocks.

I don’t want to belabor the metaphor, but what’s important is that the more you research a movie, the more you appreciate it…up to a point. (I don’t have a lot of patience for the kind of film buffs who obsess about the minutiae of cast lists and other trivia.)

And the more research you do on a stock, the better your results will be…up to a point.

The kind of research I’m talking about is the kind that makes you an instant expert. That’s someone who can take in lots of information, make sense of it, make a decision about it, and then mentally throw it into the shredder.

Once you have done the research on a stock—which will probably include revenue and earnings history, the chart (price and volume tendencies, resistance and support levels, patterns, trends, gaps, and splits), and the competitive landscape—you will make a decision to buy or not buy based on what you find. Plus, you’ll take into account the general health of the market.

But once your decision is made and you’ve bought the stock, you can probably toss much of that instant expertise into your mental recycling bin. It won’t do you any good.

A stock that you own should be managed by looking at its chart, with occasional glances at any new headlines or earnings results that pop up.

A stock’s chart will tell you all you need to know, because it’s a record of every buying and selling decision made by every investor in the market. If price and trading volume are rising, the sun is out and everything’s fine. If price is going up and volume is dropping, you need to be paying special attention, and maybe considering a little profit taking.

I answer a lot of questions from investors who want to know why a stock is going up or down. Sometimes I can even tell them why, especially if there’s an earnings report or an analyst’s rating change involved.

But in a more fundamental sense, you don’t really need to know why a stock is going up or down. If the direction is down, it probably means that all of your instant expertise won’t pay off, at least in the short run.

The bottom line here is that you should try to avoid falling in love with your own research. Your instant expertise about a company can bring you to a buying decision that represents favorable odds.

But if the stock’s chart doesn’t confirm your bet, it makes no difference that your research showed that the price should be going up. Stocks love to laugh at our expertise; it’s one of those things that keep us humble. Don’t fight the chart.

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