Further, there are three more important points that deserve a quick note.
1. Never try to catch a falling knife
These are known as stocks that have had a huge drop in value over a short period of time. Sometimes as much as 50-80%. Imagine for a second that you were considering an investment opportunity only to see it drop 50% over the last 2 days. You can’t believe your eyes. You thought it was a good value before the collapse, yet now the stock is being given away. Literally. You can’t stop salivating and/or thinking how much money you are going to make. STOP.
NEVER invest in falling knifes. Forget about your fundamental analysis or Intrinsic Value calculation. NEVER buy into this situation from both technical and timing perspective. I will describe this further in the timing section, but the chances are high that such stocks will continue to decline even further before experiencing stabilization or a recovery. Do not worry, in 99% of the time you will have plenty of time to pick up such stocks long after the collapse. Very rarely will you see stocks that have experienced a large drop in value over a short period of time show a “V” shape type of a recovery. It happens, but very rarely.
I have made this mistakes a number of times in my early days, but will never make it again. As such and as a general rule, avoid falling knifes like your life depends on it.
2. Avoid Penny Stocks.
It is very tempting to buy a $0.25 stock in hopes that if it goes to just $5, you will walk away with making 20x on your money. We always hear stories how someone, somewhere has made such a killing and turned their $5,000 into $1 Million within a year. Clearly understand, this is just hype perpetuated by day traders and people trying to sell you newsletters or the penny stocks themselves.
I don’t know of a single person who has made any real money investing in the penny stocks over an extended period of time. You might get lucky here and there, but the risk associated with investing in penny stocks is just too much for an average person. You don’t see Warren Buffett, George Soros, Jim Rogers and other top fund managers investing in penny stocks and neither should you.
3. Concentration or Diversification
A whole book can be written about pros and cons of both concentration and diversification. Which one is better? Well, that really depends on your personal specification and your risk profile. For me, concentration is a much better way to invest especially if you concentrate only on Rocket Ships and Waking Beasts described above.
The problem is, if you concentrate only on two such categories chances are you will not be able to identify more than 3-10 such stocks (in normal market conditions). Personally, I like concentration on such stocks as they provide me with the lowest risk and the highest return profile. Warren Buffett has the same approach.
Yet, it also depends on how you define risk. Is it more risky to hold 1 stock purchased at a significant discount, a stock you have fully analyzed and know everything about, a stock that you expect to appreciate significantly -OR- is it more risky to hold 30 stocks your don’t really know that well.
One again, that is a personal choice that you would have to make. If you are new to investing, I would recommend you to diversify at first and then slowly move towards concentration as you gain more knowledge and experience.
Summary: This chapter discusses various attributes of different value stocks by showing you that not all area created equal. It further suggests that you should concentrate on Rocket Ships and Waking Beasts as your primary investments vehicles. Such stocks tend to provide investors with the lowest risk and the highest return profile. Further, the chapter encourages you to avoid falling knifes and penny stocks. Finally, it shows that diversification or concentration should be based on your personal preferences and/or risk profile.
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