The Single Biggest Mistake Keeping You From Bagging Huge Gains
The moment the market opens, my inbox gets flooded with alerts I’ve set up to notify me when a holding makes a big move, hits a stop-loss, releases important news, etc.
This week, I was inundated with messages telling me several of my holdings hit 52-week highs. In fact, in just one day, I received 13 different alerts for stocks hitting new highs.
As a momentum investor, I welcome price strength in our holdings. It means our stocks are performing well and should continue to do so in the coming months.
But to a huge portion of the investing community, a stock hitting a 52-week high strikes a Pavlovian response — they immediately want to sell. After all, one of the first lessons new investors are taught is to “buy low, sell high.”
This can turn out to be a huge mistake.
There is a strong likelihood that stocks will continue to do well when they are at or near new 52-week highs, a phenomenon confirmed recently by researchers Thomas J. George and Chuan-Yang Hwang.
Their research shows that the closer a stock’s current price is to its 52-week high, the stronger that stock’s performance will be in the following months.
You see, most investors are initially reluctant to buy stocks near 52-week highs, regardless of any positive news or information about the company. I suspect this is due to “buy low, sell high” conditioning. The result is that stocks hitting 52-week highs can actually end up being undervalued.
Then, according to George and Hwang, when the positive information about a company is finally accepted, the reluctance to buy at its 52-week high gets thrown aside and the market “wakes up” and sends the stock to even higher levels.
While this research confirms what momentum investors know — that stocks with high relative strength tend to continue outperforming the market — many investors get nervous when stocks are at highs and bail out.
This is exactly the wrong way to approach your trading.
Think about this: How many times have you made the mistake of selling a big winner way too early — right before that stock makes another big move? If you’re like many investors, I suspect the number is higher than you care to admit.
But there’s more than just anecdotal evidence that proves the thesis that investors sell too early. Research from 1997 by Terrance Odean, a finance professor at the University of California, Berkeley’s Haas School of Business, shows that the stocks investors sold actually outperformed the stocks investors held by roughly 3.4 percentage points in the 12 months following the sale.
Considering that the average individual investor generated annualized returns of 2.1% from 1992 to 2012, the 3.4% investors are leaving on the table is huge.
I’m not ashamed to admit that there are times I want to take profits on big winners in my premium newsletter, Alpha Trader. But, more often than not, it would be the wrong decision. Take Bitauto Holdings (NYSE: BITA), for example, a stock recommended in October. Shares were up 104% by May 30, 126% one month later, and 178% only 30 days after that.
When would you normally try to take a profit? When a stock is up 25%… 50%… 100%… 200%?
Today, we’re up an incredible 330%. And BITA is just one of eight stocks we hold that are up 50% or more.
Instead of trying to guess the best time to take a profit, we eliminate emotions like greed and fear that can hurt our returns by relying on a rules-based system in Alpha Trader. We only purchase stocks with strong momentum and cash flow growth and sell when momentum starts to fade.
Our proven, rules-based system removes emotion, conditioning and other psychological factors from our decision-making process. The objective nature of our trading is the secret to our success so far.
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