The Worst Reason to Buy a Stock

The Worst Reason to Buy a Stock

Oh dear. The news just keeps getting worse for shareholders in AMP [ASX:AMP].

The company has now copped a credit downgrade from rating agency Standard and Poor’s.

It will duly get another slap across the cheek in the market today.

Why bring this up?

There is a lesson to be gleaned from this sorry tale. It springs to mind because of my suffering gym buddy, John.

You might remember I mentioned him a few weeks ago.

He took a punt in a small-cap stock called Netlinkz [ASX:NET] based off a buddy’s tip. That’s not working out for him, last time I checked.

But we originally connected over the Banking Royal Commission.

John happened to mention that he bought into AMP after the stock started selling off around this.

That’s a bad move. Learn from this! It could save you thousands…

I never understood his rationale for buying AMP. He muttered something about AMP owning a skyscraper in every major capital city.

But John made an easy mistake… He got greedy at the thought of ‘grabbing a bargain’.

Let’s take a look at how AMP has been travelling via the stock price lately…

Source: Optuma

Not pretty, right?

This is the danger you run when you go bargain hunting in the stock market.

You run the risk of buying a stock nobody wants. Some shareholders love nothing more than to offload their crappy stock to any unsuspecting person they can find.

Any recent buy in AMP has been — sorry, John — a poor decision.

That’s not to say I’m Mr Smart and can’t make mistakes. But AMP is a perfect example of why you do have to think very critically about whether the odds of buying are in your favour.

Never buy a stock below this level

Nobody gets every stock buy right. We can take that as gospel.

The trick is to find setups where the reward is as high as you can find, relative to the risk you take in going after it.

To me, AMP just didn’t have enough upside to justify buying it.

Why anyone would think this situation was going to resolve itself quickly is a mystery to me.

And yet many people have been buying AMP lately — all the way down.

I used to work with a trader who had a simple rule: Never buy a stock trading below a moving average. The idea was to avoid big downtrends, like the one you can see in AMP.

This rule is not a bad thing to keep in the back of your mind. Consider it a rule of thumb.

It’s perfectly fine to buy a stock if you identify a strong catalyst that can shift the need back up.

For example, one of my recommended oil stocks announced a good strike on Monday — and has risen 30% in the last two days. We’ll see how that plays out from here.

The main point is that you need to make sure you know — as much as possible — what can change the current market dynamic to drive your choice of stock up.

Being ‘cheap’ is not good enough, I’m afraid. Stocks can become so cheap they go all the way to zero.

My sister called me up a while ago and asked whether she should buy the stock in the company she worked for at the time.

Her rationale?

The share market is not a supermarket

That the stock was ‘cheap as chips’.

See? There it is again. We humans have an impulse to go after things that are down in price.

That works at the supermarket. It can be dangerous in the stock market.

Don’t get me wrong.

If you’ve done a heap of homework on a stock and know the business well, and you think you can take advantage of what appears to be a short-term dip, by all means go for it.

But it goes back to the above. You just better make sure you know why this is likely a potential dip and not the market signalling something is wrong.

Nope — it’s never easy to distinguish the two. Mr Market never promises to make things easy.

It probably helps to write down your reasons when you buy a stock. Then you can compare your original thesis to what happens later.

But if you remember nothing else, keep this warning in mind: If you’re buying a stock because it’s cheap and nothing else, watch out.

Best wishes,

Callum Newman Signature

Callum Newman,
Editor, Profit Watch