Have You Ever Bought A Rallying Stock Just To See It Plunge The Next Day?

Includes: BAC, NLY, SPY, XOM
by: Jacob Steinberg

I am sure this has happened to everyone who is reading this article at the moment at one point or another. You add a stock to your watch-list, you watch it rally relentlessly for weeks, everyone suggests buying that stock, all the analysts are raising their price targets on it, and as soon as you buy the stock -- the very next day -- it starts to plunge, and then all of a sudden everyone is bearish on the stock. Then you decide to sell your stock and as soon as you sell it, it starts rallying again. It makes you think there is someone really powerful behind the scenes and he's manipulating the market in order to cause you the maximum loss possible. Yes, it happens to more people than you think.

Why does it happen and how do you avoid it? It happens because the market is full of rallies and plunges. There is no stock that rallies every day, and there is no stock that plunges every day. Even the most bullish stocks have corrections, take breathers and see pullbacks once in a while. This is completely normal. Just because a stock has been up for 10 straight days doesn't necessarily mean it will be up for the 11th day. It may or may not be up for the 11th day, but the first 10 days don't guarantee an 11th day by all means.

I've set myself some rules in order to avoid this problem, or at least minimize it. I am not saying these are the rules to go by, however these are the rules I follow and they usually work.

1) Don't put too much faith in the trend. The trend is your friend until it isn't. In today's volatile stock market, it is really easy for a trend to turn upside down within no time. For example, look at Bank of America (NYSE:BAC) that plunged from $12 to $4.90 and then rallied up to $9.50 and now is on its way down back to $6. This all happened within a matter of months. Another example is Apple (NASDAQ:AAPL). It moved from $400s to $648 in a matter of weeks, and now it's on its way below $500. Soon it will be rallying again, perhaps to $700. As a rule of thumb, if a stock has been rallying for 2 weeks, I would avoid it until it has a correction or pullback. Yes, when a stock is rallying non-stop like Apple did in the beginning of the year, it will look like pullback will never come and the stock will rally to the moon, however, no matter how good a company/stock is, it will always have corrections and pullbacks along the way.

2) Don't be a knife-catcher either. If you notice a correction/pullback in your favorite stock, don't jump into buying it yet. You never know how much lower it can get. Again, I will use Apple as an example. When the stock moved down from $648 to $600, many people thought the correction was over and it was not safe to buy the stock, however the stock value lost another $70 since then. Just like rallies, corrections don't last forever either. Be patient and wait for the stock to be done with its correction. A stock will be usually done with its correction when it's up 2-3 days in a row after the correction has started.

3) If you are a long term investor, don't watch everyday prices of a stock. In the long run, a stock's price always catches up with its fundamentals. Sometimes this takes a while, but at the end of the day, this always happens. If you bought a stock based on its solid fundamentals and strong growth potential, don't stress yourself with where the stock price is going to be the next day. Who cares if a stock is up or down 1% tomorrow, if I don't plan on selling my stocks for another 10 years? Save yourself some stress and this will help reduce your healthcare costs too.

4) Don't invest the money you'll need in the next 12 months to stock market. If you are planning to save money for down payment of a house or another large payment, don't put that money in the stock market unless you are ok with delaying your plans or canceling them altogether. The only exception to this rule is current income such as dividends and option writing. You will have access to this money pretty often.

5) Don't buy or sell stocks based on emotions. I know, this is an easy thing to say and a very difficult thing to actually do. It is perfectly normal for humans to have emotions such as excitement, fear and even ones like greed. You don't need to feel guilty about having these emotions; however, you should avoid acting on them in the stock market. When you put your hard-earned money in your favorite stock, it is very heartbreaking to see it plunge 3-4% the very next day, but if you sell your stock based on fear, you will lose part of your money forever. If you keep the stock, you will get your money back sooner or later as long as you picked the stock based on strong fundamentals.

6) Don't forget that in the short term, a stock is only worth as much as market thinks it is worth. A stock can have a P/E of 1 or 100, it can have a price to book ratio of 0.1 or 10, it can have lots of debt, and lots of cash; in the short term, none of these will matter. If the market thinks a stock is worth $400, it will be worth $400. In the short term, the market can and will assign a P/E ratio of 55 to companies like Chipotle (NYSE:CMG) and 11 to companies like Apple. Is it irrational? Yes it is. But it does happen and you should keep this in mind. If you are a long term investor, don't worry as the stock price will catch up with the fundamentals sooner or later. If you are a short term investor, know that watching the current market sentiment is as important as -- if not more important -- everything else such as technicals and fundamentals.

7) If you don't have strong enough nerves for the volatility of the stock market, I suggest buying either index funds like (NYSEARCA:SPY) or stocks that pay high rate of dividends such as Annaly Capital (NYSE:NLY). There is no bet in the stock market that's 100% safe; however these will be relatively safe. Also you may focus on stocks like Exxon Mobil (NYSE:XOM) as some of these stocks will be even less volatile than stock indexes. During the last recession of 2009, Exxon Mobil only lost about 25% of its value whereas S&P index lost more than 60% of its value.

In conclusion it's very important to be calm and patient in the stock market. Those who are able to keep calm and patient are the ones that get to enjoy the best returns and very likely early retirement. Every time I sold a stock too early due to panic or fear, I always regretted it. I know someone who sold all his Apple shares last summer when it plunged from $385 to $360, fearing that the company's price would go down to $200. Within the next year, the stock price passed $600.

I welcome any comments on this. Have you guys ever sold a stock on panic and regretted it afterwards?

Disclosure: I am long AAPL, XOM, BAC, NLY.