Knowing When to Buy and Sell Stock

Everyone knows that old saying that the key to investing success is to buy low and sell high.  While any dummy can understand the importance of that, putting it to practice is much more difficult.  The two major schools of thought for predicting stock movements are fundamental analysis and technical analysis.

Technical Analysis

Technical analysis uses historical pricing to predict future movements of a stock’s price.  Commonly, technical analysts will look at the moving average of a stock over a fixed time period, such as 50 day, 100 day, and 200 day, to establish a baseline price and maximum price to build a range for the stock.  If it hits the baseline, many traders believe that the stock can only go up.  If it hits the top of the range, they believe it can only go down.

Note that I refer to people that follow this method as traders, as opposed to investors.  As a general rule, people who focus on technical analysis are not buying stocks for the long run; they are looking for short term wins.  I personally rate this method just a step ahead of gambling.  Most day trades and short term sales are all based on technical analysis, which does not take into account how the company’s financial situation (fundamentals) and the overall markets are doing as a whole.

My preferred technical indicator when reading technical analysis charts are Bollinger bands.  Created by John Bollinger in the 1980s, Bollinger bands create a low, middle, and upper band based on the volatility and moving average of the stock.

Just remember, if you are looking at technical charts, your investments are based on stock market trends.  We all know that the past might be helpful but is not a sure bet in predicting the future.

Fundamental Analysis

Fundamental analysis looks at a company’s current and projected (pro-forma) financial situation to decide what the company is worth today.  Most mutual fund managers use fundamental analysis for their purchase decisions.  Warren Buffet’s value investing strategy is also based on a company’s fundamentals.

The main inputs for fundamental analysis are the balance sheet and income statement.  Those statements, released quarterly by each public company, tell about the financial health of the company.  Using those statements, analysts build predictions of future growth and performance.  Those pro-forma statements are based on industry trends, company trends, the economy, and major news impacting the company’s business.

Once a pro-forma balance sheet and income statement are created, the most common valuation for a company is a free cash flow analysis.  Investopedia defines free cash flow, often referred to as FCF, as operating cash flow minus capital expenditures.  A free cash flow is discounted based on a company’s risk level to create a total enterprise value.  Divide the company value by the number of shares of common stock outstanding to find the intrinsic value of a share of stock.

If the intrinsic value of a share is higher than today’s market price, it is considered a “buy.”  If it is within a very close range, it is a “hold.”  If it is below the market price, it is rated given a “sell” rating.  Some investment analysts have more rating categories and use different names, but they are essentially giving you this information.  For example, outperform, market perform, and underperform correlate to buy, hold, and sell respectively.

Emotion

One thing to completely take out of the picture is trading with emotion.  Emotional investing leads to stock market crashes, selling at the wrong time, and buying at the wrong time.  If you have done well with a stock and want to keep the profits, it is best to decide if the stock is still undervalued.  If it is, why would you ever sell?  The same goes for buying.  If a stock has done really well recently, it is generally a bad time to buy it.  You already missed the big gain and will lose money if it goes back down.

Whenever you are going to click the buy or sell button, don’t think of what you have already gained or lost unless you are taking taxes into account.  What has happened is done.  Those are sunk costs.  Only buy and sell based on the future.

Conclusion: What Should You Do?

I think the best method for deciding when to buy and sell is to conduct a fundamental analysis yourself and take the technical analysis into account as a secondary valuation method.  If you think a stock is wildly undervalued, it is probably a good idea to buy it even if it has trended down lately.  I always rank fundamentals ahead of technicals.

You are never going to be right 100% of the time.  My portfolio is up 30% as a whole, but I do have two stocks that are down at the moment.  I just stick to my intelligence, not my emotion, and trust that my analysis is correct.  So far, it has worked pretty well for me.  I am up just under 15% per year since I started investing.  I hope you have the same luck success as me.

Please share your investment strategy and how well your investments have performed in the comments.