Application of Stock Picking Basics (3)

About a week and a half ago, I checked out CNN Money before I went to work to find that the S&P 500 index had dropped over 90% to 134.42!!!

CNN Money Front Page Error

Realizing that the Dow and Nasdaq were down 1.64% and 1.73% respectively, I realized that there was no way that the S&P 500 would be down such a scary percentage. Turns out that CNN Money had some kind of error where the price would be fluctuating from the erroneous value of a 90% drop to a more respectable 1-2% drop. While you probably won’t live to see a 90% drop in the S&P 500 or Dow, you will live to see tough times where the markets drop a lot in a very short amount of time. Some people run for the hills, some people don’t even want to check the prices of the stocks they own, and some people see it as a golden opportunity to buy stocks that are oversold.  After the dot com crash in 2001 and 2002, a lot of people lost serious amounts of money. On the other hand, people who invested in late 2002 and early 2003 were probably rewarded very nicely as the market escalated consistently for over four years. When investing, keep two things in mind when you have extraordinary declines in the market: cash is a beautiful friend and you don’t need to buy shares all at once.

Keep Cash on the Side

If you invest all your money at once, you handcuff yourself from opportunities when the market has declined. Since investors can’t always predict how the market will act, it is wise to keep uninvested funds available just in case stocks get depressed to prices where you see the stocks as oversold. It’s terrible to see a great buy available only to know that you can’t do anything about because you don’t have the funds to buy.

Buy in Increments Since Trading Fees are Cheap

Most investors don’t deal directly with a brokerage firm and pay exorbitant trading fees of around $100 per trade. Those days are generally over and now you can instead pay $7/trade through Scottrade or $12.99/trade through Etrade. What this allows investors to do is be more conservative with their trades by splitting up purchases of a particular stock. Say you want to buy 100 shares of Monsanto Company (MON) at $107. Instead of buying all 100 shares at $107, you can instead start by buying 50 shares at $107. Then go ahead and put a limit order of $97 to buy another 50 shares. What this does is protect you a bit of any fall in Monsanto when you buy it. If it happens to drop to $97, your average is $102/share and you’re getting it cheaper than by just buying your initial 100 shares at $107. If you like Monsanto so much, then it shouldn’t be a problem if it drops and you buy more shares because you were planning on purchasing 100 shares in the first place anyways. If Monsanto happens to increase in value and rises to $125/share, then you just made yourself a nice 16.8% gain on your 50 shares. Sure, you could have made double by buying all 100 shares in the first place, but this is a good way to protect yourself when there is downside. With this volatile market we are experiencing, buying in increments would be a good strategy to enforce throughout the rest of 2008.

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