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Tips To Avoid A Common Investing Mistake

|Includes: Buffalo Wild Wings, Inc. (BWLD), CMG, COG, DDD, FB, GLD, GME, NFLX, OPEN, SFM, TSLA


Do not use vague rationalizations as your reasoning to make a trade.

Use empirical data that you gather from your research to make decisions on when to buy stock.

If you just look at broad trends you will be mistiming the market.

I believe that investing is both an art and a science. This allows there to be many errors among traders. I would like to focus on something that I feel is a common mistake among investors. This mistake is rationalizing a position based on vague theses that aren't reliant on numerical data. I am not stating that indicators such as sentiment are not important. I am saying that people often defend their positions in certain stocks by pointing out facts that would be true whether the stock they own is at 100 or 30. When you do this you are certainly mistiming the market because your evidence is not based on the ever changing numerical data that is appearing each day. Maybe your goal isn't to time the market, but mine certainly is. I believe that timing the market is possible, but falling into the pitfall that I am describing will definitely misguide you and eat away at your precious returns.

There are certainly obvious ridiculous market calls that aren't based on data. I believe that most moderately sophisticated market participants can spot these a mile away. An example of this would be the old Wall Street adage "sell in May go away". Obviously Fed policies and the market's valuations are not used in this nonsensical phrase. It definitely is possible that this is correct advice, but this would be evidence of correlation not causation.

Trends are certainly important metrics to form rationality for your research, but the numbers are the actual proof that the timing is correct. For example, in my first article on Sprouts Farmers Market (NASDAQ:SFM), I stated the trend which was that there will be an increase in organic food shopping. This was the reason for doing further research on the company. If I would have simply said that healthy eating trend was a good reason to buy the stock for the long term and left it at that, then this would have been a faulty thesis. This is what I feel that many novice individual investors do. If this simple reasoning, which is definitely cogent and backed up by factual evidence, was the only reasoning for buying the stock it would be wrong because of the fact that this argument could have been made to buy the stock at $40 a share and this would have lost you money. Judging market sentiment and trying to go against the grain, while also using valuation metrics to value the company would have allowed you to buy the stock at the correct time. This is how I was able to pick off Sprouts as a buy and get the timing perfectly right. This is my article.

SFM Chart

SFM data by YCharts

When you are determining whether or not to make a trade on a company's stock it is important to ignore emotions and try to determine whether a particular argument could have been made when the stock was trading at a different value. This point that I am making works perfectly when describing how Tesla (NASDAQ:TSLA) was described to me by individual investors. While the company's stock probably has made most investors profits, it is certainly not enough to only state that the electric car industry is going to expand and Elon Musk is the perfect transformational CEO to guide the company to eventually dominate to industry as your reasons for buying the stock. These can be made when the stock price is at $30 or $200, so they will lead you astray when deciding when to purchase a security. It may seem like an obvious thing to do, but I'm sure that many people bought Tesla based on this idea. You can do countless hours of research on the electric car market and the history of Elon Musk's innovative past, but it would not be enough reasoning to buy the firm's stock. You may be saying to yourself that valuation metrics are rubbish and that they would have kept you out of a stock such as Tesla. I disagree with this because your valuation of Tesla would depend on your earnings predictions for the company. As new information was released this year it became clearer that most analysts' estimates were too low and the stock rose. Certainly if you would have done the numerical research on the company's earnings projections before the stock rose then it would've appeared reasonably valued and possibly a buy. With regards to deciding on whether to trade the stock when it was in the $100 range, your measuring of sentiment and momentum could have still guided you in the right direction. The momentum indicator that I use is the 14 day relative strength index. When it is above 70 the stock is overbought and when it is below 30 the stock is oversold.

So far I have provided you with examples where losses did not occur. The next example will explain how I made this same mistake in investing rationale and it cost me money. About 2 years ago I purchased the gold exchange traded fund GLD (NYSEARCA:GLD) which tracks the price of gold. I purchased it for reasons I am sure many investors are aware of. The rising debt and deficit of America was my reasoning behind buying gold. This argument did not provide a valuation of gold and could have been made at any price. This argument would not tell me when to sell gold; it would not tell me when the huge American deficit was properly discounted into the price of the commodity. Personally, I am not a commodities trader so I couldn't tell you the exact metrics to value gold based off of. This doesn't matter for this argument. The point is that you have to be very weary of arguments to the buy or sell a security that are not determined by valuation or sentiment metrics. Metrics that are changeable will be better at steering you in the right direction with regards to market timing.

The evidence of my point in this article is shown when companies that are doing poorly have stock prices that increase. GameStop (NYSE:GME) would be an example of this because the trend of gamers downloading games instead of purchasing them in the stores is self evident. This thesis that is not based on valuation metrics or same store sales predictions would have kept you out of a winning stock in 2013.

I will delve deeper into my specific market timing strategies. As an individual investor, I certainly do not have access to fancy trading platforms that you see advertized on TV. What I decided to do was make a watch list of stocks that I believed had really solid long term potential, such as Open Table (NASDAQ:OPEN), 3D Systems (NYSE:DDD), Chipotle (NYSE:CMG), Buffalo Wild Wings (BWLD), Facebook (NASDAQ:FB), Netflix (NASDAQ:NFLX), and Cabot Oil and Gas (NYSE:COG). For me as an investor when I initially hear of a good investment opportunity in the news, on seeking alpha, or by doing research on another company and stumbling upon it, I immediately get the urge to purchase it. By putting it in a basket and finding out a number of stocks that I would like to purchase, which is in excess of the amount of securities that I would prefer to own, it allows me to view stocks in a more logical less emotional manner. I decided that I would only look into the stock if it had a huge decrease, partly because most of these companies are highly valued. This is how I was able to recently spot DDD and purchase it in the low 50s and high 40s. So far I am up about 15% in the stock in about a month's time. This was also how I was able to profit off of Netflix's recent rise. Unfortunately, I did not end up purchasing Open Table before the Priceline offer, but I can say that this methodology put the stock in front of me to analyze before it had the huge move upwards.

That was my method of how I was able to time the market recently. Of course this was just an overview of how I screened investment opportunities. I did much more in depth research as I explained in my Sprouts Farmers Market article. I wanted to go into more specifics quickly to explain how I was able to make profits on Sprouts. The main take away from this article, however, is that you should use numerical metrics to value a security besides simply using a broad trend that has no way of telling you how to time your trades.

This article's take away may cause you to miss opportunities that seem easy to act upon, but it also will allow you to avoid losses like the ones that I had in gold. My methodology that I quickly described may seem simple, but I thought was worth mentioning, since it helped me make outsized profits this year. Of course, it is dependent upon putting the correct stocks in your basket and this requires many hours of research.

Disclosure: The author is long DDD. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.