Trading Lesson: Market Declines Are Buying Opportunities
01/12/2018 11:30 am EST
Investors and traders looking to buy low should consider four fundamental ideas, writes Steve Pomeranz, CFP. Look for guides on how to get started trading every Friday.
Every investor knows the mantra by heart: Buy low and sell high. And every serious investor equally knows that it's well-nigh impossible to consistently buy at the lowest low and sell at the highest high.
That said, investors can do very well if they generally buy near all-time lows and generally sell near all-time highs or, ideally, buy near all-time lows and "hold forever," which is Warren Buffett's favorite holding period.
So, in this spirit of buying low, I want you to consider seeing declines in the stock market as potential opportunities to buy stocks low, not simply as calamities that should have you worried.
Here's a quick test: Let's say you own shares in a well-known company- let's just go with a famous phone company that's trading at about $100 per share, strictly for illustrative purposes.
Now, honestly ask yourself, how would you react if those shares fell to $92-with fear and anxiety or with exhilaration? My guess is many investors will get pretty nervous and think that drop to $92 portends a drop to lower lows (especially as they eye their statements at the end of the month). But only a handful who truly understand the company will have the courage to go in and buy.
So, I want to share a few tips with you today on how you can train yourself to buy solid stocks more often when they fall to attractive lows.
Just to be clear, I am not saying you should buy each time a stock falls to new lows. The key is buying solid companies that have been temporarily beaten down but have great business fundamentals and have potential to rise back up again, sort of like some major energy stocks that took it on the chin on falling oil prices.
"Look at market fluctuations as your friend rather than your enemy."
A prudent strategy is to invest in high-quality industry leaders that may withstand further adversity and will benefit as their competitors go broke.
As Warren Buffett says, "Look at market fluctuations as your friend rather than your enemy."
Here are a few things I want you to keep in mind so you may buy low more strategically:
1. First-and this is absolutely key-research your investments very thoroughly before you buy.
If you were truly investing every dime you had in one business, I'm sure you would do all your homework! Then when you do buy shares, don't panic if the stock falls lower; be calm and focus on being a part-owner in a great business, with you invested in it for the long haul.
And, remember, you will rarely triple or quadruple your investment by purchasing a stock when everyone is lusting for it, so price drops at great companies may be a blessing in disguise.
2. Avoid the psychological torment of falling share prices by engaging in dollar-cost averaging.
The next time the price of your favorite well-researched stock (or mutual fund or ETF) falls, contemplate acquiring a bigger stake in the business for less. Some investors put a set amount of money into their favorite investments each month or quarter or year. By investing in stocks as its prices fall, you're engaging in dollar-cost averaging, a technique designed to attempt compounded wealth accumulation over time. For example, if you invest $1,000 a month and the stock you love trades at $100, you'll add 10 shares to your portfolio. If the stock plummets to $83 the next month, your $1,000 will fetch 12 shares.
When you dollar-cost average, instead of feeling as if you're losing wealth, you may feel as if you're gaining it. While investing in this manner doesn't guarantee results-especially if the stock does not ever recover-it is widely used by investors, including Warren Buffett. He's no dummy!
3. Make a wish list.
As I keep saying, before you go headlong into investing, I want you to literally spend months researching companies that fit your risk profile and investing needs. And while this used to be a daunting task, online stock-screening tools offered by most brokers make stock screening so much easier.
So, use these tools and develop a small and manageable wish list of stocks, bonds, ETFs or other assets you'd like to invest in. Then do your research to understand the company and how they make their money and get to know their price history and the way the market values them over a long period of time.
Then write down prices at which you'd be thrilled to own these stocks, but be realistic and give them reasonable valuations. Then when these wish-list stocks approach your valuations, dive in to make market declines your friend-something you can only do if you've researched the company well.
4. Capitalize on the myopia of your fellow investors.
Here's another thing I can say: Markets don't always price companies fairly. For example, when a company runs into trouble, the market frequently assumes that the problem will continue. The truth is that you don't have to know how a company will solve its current problem.
You just have to look at the firm's fundamentals, its track record of handling past problems and the ability of its management to tackle the issue at hand and move ahead. The quality, experience and longevity of the company's management are absolutely key. Warren Buffett invests in great businesses run by even greater people and leaves them alone to do their thing after he buys the business. Management risk is a factor for investors holding stock in a company.
So, make sure you know the company's management well in order to take advantage of mispricing opportunities. Peter Lynch, the great manager of the Fidelity Magellan fund, is also famous for saying: "Buy companies that even an idiot can run because eventually an idiot will!"
So, stick with tried and true businesses.
And one last piece of advice: Instead of thinking of the stock you've bought as a piece of paper that goes up and down willy-nilly day in and day out, think of it as a purchase of a minority interest in a business.
If you are patient and diligent and follow the four steps I just listed, you may be rewarded.
And remember the words of that grumpy old man, J.P. Morgan. When asked by a young elevator operator what the stock market would do, the great financier replied, "It will fluctuate, my boy. It will fluctuate."
So, hang in there and wait for stocks to swing your way!
To find out more, go to www.stevepomeranz.com