The decision to buy a stock always begins with two things: Strategy and Homework. By “strategy,” I mean you need to articulate a reason—right up front—as to why you want to buy the stock. A key distinction you must make (and clarify in your own mind) is whether you are buying it as a trade, or whether you are buying it as an investment. Let us clarify these terms. A trade will have a particular catalyst that you believe is about to drive it higher.
Think of a catalyst as a specific piece of news that when Wall Street hears it, they will drive up the price of the stock. This can be something as mundane as the company beat earnings estimates by a few cents, or something as momentous as a war starting in the Middle East. You may decide that such a war will hamper oil production in the Middle East, oil prices will surge upward, and American production companies will shoot up in value. You buy American oil company stocks before the price shoots up and make a large profit. That would be a great story (except for the war part). When the event occurs, and both Wall Street and Main Street knows that it has happened, that is the time to take profit from your trade.
What if the war never really got started? Let’s say that the Russians brokered a peace deal just before things got really ugly. You got into the oil stock as it was surging upward, and it falls back down below where you bought it because there is no war and thus no slowdown in Middle East production. Now you have a bunch of stock that is down. The right thing to do, according to Mr. Cramer’s rule, is to accept the fact that you called the move wrong and sell, taking the loss. The alternative would be to convince yourself that the down stock is a good investment and that you shouldn’t sell it at a loss. This will almost never be a successful approach! If a trade goes south, sell. The odds are good that you would never have purchased that stock in the first place if you didn’t think the catalyst was going to occur. If it doesn’t occur, then you have no reason to own the stock and are open to a huge downside loss.
In finance, mean reversion refers to the idea that when a price becomes extreme, it will tend to go back toward average in the future. Some sources regard this is a finance “theory,” but social scientists will recognize it as a statistical axiom, but they will only recognize it if you call it regression (as in regression analysis). Francis Galton coined the term “regression” in the nineteenth century to describe a biological phenomenon he observed where the heights of descendants of tall ancestors tend to regress down towards a normal average, which he called “regression toward the mean.”
When scientists started looking for it, they found it everywhere. If you are a B student, sometimes you will make an A. On the next text, the odds are very good that you will make a B—you have regressed toward the mean. If you make an F on the next test, you will likely make a B in the subsequent test. You regress toward your mean on any measure of performance. When it comes to stocks, I like to think of prices reverting to the regression line rather than the mean since stock prices are supposed to appreciate.
This is one of the only technical indicators (if it can be called that) that I have any faith in. If you need to rebalance your portfolio, buying an index mutual fund is a good idea when it is down 20%. You must exercise caution with individual stocks as extreme values may reflect fundamental conditions with the company. A lot of investors lost money buying GE at $17 thinking it would quickly revert to the mean. Management misled investors, and there were “accounting irregularities.” It ended up being what investors call a “falling knife,” which is something you do not want to catch.
With an investment, the logic is very different, and the time horizon is usually much longer. The idea of an investment is to buy into a stock that represents a great company with great fundamentals. You need to believe (based on facts!) that the stock is selling at a discount and Wall Street will eventually realize that it had the thing priced too cheap. In the case of an investment, you actually want to see short-term drops in the price so you can buy more of it at a lower price. This is such an important concept that Jim Cramer recommends only buying a fraction of what you ultimately want to own, and then wait for a “pullback” before buying more. His rule is never to buy a stock all at once. Of course, you will have to weight this rule against the size of your position and the costs of making trades. If you are managing a very small portfolio, brokerage fees may rob you of the advantage.
The absolute best time to make investments is when the market is down substantially (undergoing a major correction), and investors are fleeing in panic. Panic fueled selloffs cause the price of stocks to go down across the board, almost completely independent of the intrinsic value of the underlying companies. That really defines the secret to making money in the stock market. You need to be completely rational in the stocks that you pick, and buy them when the vast majority of investors are being irrational and running around in panic selling great stocks at stupid prices. Note that this behavior defines the EMH, and is one of the reasons that I believe the theory to be imperfect.