May 4, 2006

Your Favorite Stocks May Not Be The Best Investments

Decisions about which stocks to purchase should be objective, but many times our emotions and personal “attachments” to stocks play a more significant role than they should. Research studies by behavioral economists have shown that social psychological factors, such as the public image of a company, play a significant role in the way a stock moves. For example, consider the media coverage of oil companies right now. With all the profits we’ve been hearing about, how can you resist not trading these stocks? It may be difficult to stay away.

In choosing a stock to trade, many traders try to identify a “great buy” or “sure winner,” but what factors should traders actually consider when making this decision? Should it merely be based on an "image" or something more tangible? Are you actually considering a factor that has a direct bearing on whether the stock in the company is worth an investment? A common mistake among traders is to base trading decisions on hype and image, rather than on factors that will actually produce trading profits, such as current price patterns, volume, or momentum indicators.

Think of all the companies in recent history that were supposed to be up and coming? Tyco and Enron seemed like sure win companies with huge potential. They were viewed as great companies for long-term investments. What about General Motors? At one time, it was one of the largest companies in the world, but what about today? In recent times, you may have seen the hype about Apple Computer raise its stock price, but the high of a few months ago has yet to be seen again. If you are a short-term trader, minor fluctuations in price can pay off big, but ideally, a stock purchase should be based on more fundamental factors in addition to the more immediate factors that move the price. In other words, if the price is purely based on hype, it is easy to watch it plummet. It’s common to see a thinly traded stock surge in price due to media coverage, for example, but it may fall just as fast if the price is purely based on hype. When the masses sell, they all sell, and there are no “serious” investors left to buy the stock.

Media coverage can have a powerful impact on the behavior of the masses. But as a trader, you have to make more logical decisions than the masses. Don’t be a victim of biased analysts' predictions, media hype and the unrealistic exuberance that seems to creep up at times. In this era of trading, the "true value" of a company is a matter of debate. And despite analysts' predictions, no one can know with certainty the actual future stock price for any company, since the stock price is largely a function of the perception of the masses. Media hype, image, or shareholders' sentimental attachment to their stocks may influence prices, but as traders, it's essential to put these factors in perspective. The masses may be easily swayed by these opinions and beliefs, but you must base your trading decisions on current signals and indicators in the short-term time frame you have chosen to trade, whether intraday or intraweek. What is the basic price pattern, and how has it changed in subtle ways by media news? The price pattern, and factors such as volume and momentum are primary; the media news is secondary. Don't make the mistake of using image, sentimentality, and public opinion as primary information for making trading decisions. By all means, consider these factors, but base you primary trading strategy on more fundamental short-term indicators of momentum and trend.


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