Investor Mistake #9: Trying to "Catch a Falling Knife"

Last week's Top Ten list was the Top Ten Mistakes that Investors Make.  I already discussed #10 in greater detail in a previous post, so continuing in that vein...

#9 Trying to "catch a falling knife"

There are probably almost as many investment strategies as there are investors.  Some see a stock flying up, day after day, and think, "I've got to get me some of this."  Others don't pay any attention to the price movements, rather have a great experience with the products or employees and think, "now this is a company that is well run.  It's gotta do well."  And many others fall into another camp that says, "Man, this stock used to be at eighty bucks a share, and now it's all the way down to $40.  What a steal!"

This last group is attempting what we call, "trying to catch a falling knife."  I didn't make up the allegory, but its meaning should be obvious.  If you are not very, very careful, you are likely to get cut.

There are a few things to keep in mind if you are going to attempt to invest in a stock that has declined significantly in price.

1.  Why has it gone down so much?  Is there scandal afoot?  Are the fundamentals deteriorating?  Is the industry in a tailspin?  Has a competitor proved excessively formidable?  If any of these is the case, be very careful.  You should probably think twice, thrice, and maybe even a fourth time before investing. 

If none of these is the case, then determine if we are in a severe bear market dragging the good down with the bad.  If that is so, act with caution, you don't know how long or how severe said bear market may be.

Last, maybe none of the above applies.  Odds are what is then happening is that the stock has gotten overpriced and is coming down on valuation concerns or profit taking.  If this is the case, you may have good fundamentals, good industry, good market, but a declining stock.  Nonetheless, by buying now you are banking on the odds that it will go back to being overvalued once again.  Still, be careful.

2.  What makes you believe it has hit bottom?  In other words, do your research.  If you have reason to believe you have identified the likely bottom, whether via fundamentals, technicals, a combination of the two, or some other means, at least do your homework.  Don't jump in because some stockbroker or pal at the office said, "man, this is a great company.  It's like a sale!"

3.  What are your goals in going in to the stock?  This may sound like a silly question.  "To make money," you are probably saying.  But there's more to it than that.  Are you buying strictly for capital appreciation, or are you looking forward to a nice dividend too?  Do you think this is a good long term hold, and you have just been waiting for "your price"?  Or are you playing it for a short term gain?  Do you have an exit strategy?  If it goes up, will you sell at the first sight of a 15% gain?  or are you holding on for a double or better?  If it continues down how far are you planning to hold?  10% loss?  50% loss?  Ride it to Zero?  Hey, it happens.  Look at my list of Top Ten Defunct Companies.  Nobody thought any of these would ever go out of business.  Well, except maybe ZZZZ Best.

Bottom line is, this can be a risky way to invest.  Do your homework.

Also, note the following disclosure:  This is general advice. You should consult with your own financial advisor before making any major financial decisions, including investments or changes to your portfolio.  You, alone, are responsible for any losses or damages that may and will likely result from your financial decisions.

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