Once you have created a stock basket using one of the expert stock screens, the next key question is: when should you buy those stocks? Most people can’t resist a good bargain and rush out and buy the respective stocks only to experience their new holdings decreasing in value. Their mistake is not looking at the general trend of each stock before investing.
One of the most important investment rules is: “always go with the trend” or as they say “the trend is your friend”. Not going with the trend is comparable to swimming against the stream. It’s a bad idea.
In financial jargon an “uptrend” is called “positive momentum” and a “downtrend” is “negative momentum”. Imagine sitting on your bike at the top of a hill starting to roll down. Momentum is the increasing speed you experience during your exciting downhill journey. There is little muscle power for you to invest, if any, to make it conveniently to the bottom of the hill. That’s the invisible energy or tailwind you want to see when investing into a stock.
Price momentum is the “premier anomaly” in the investment world that you can use for your advantage – if you know how to use it the right way! Recent research has shown that momentum worked for the U.K. equity market back to the Victorian Age and for the U.S. equity market even further back in the year 1801! Research has also found that stocks that have recently risen in price tended to go even higher, while stocks that had recently fallen usually fell further. Buying a falling stock can therefore have the same effect as trying to catch a falling knife: You’re most likely going to get hurt.
How can you avoid falling stocks?
Being aware of what momentum means and does, we want to make sure that you don’t make the costly mistake of buying stocks on a downtrend, but rather buy stocks when price momentum works in your favour. As longer-term investors we don’t look for short-term profits like traders who often trade against the trend to make a few dollars. We are in for the big swings but taking a position against the trend is an expensive venture you don’t want to follow. To make your life easier using our platform, we have introduced the traffic light system (red/green) next to each stock on the list. Green means the momentum is positive (prices in the recent past have gone up), red means the momentum is negative (prices in the recent past have gone down). You should only buy stocks when they have started to move up, which is indicated with a green light.
Speaking in mathematical terms the red/green signal is generated by employing an absolute momentum rule. We look over a rolling look-back period of 6 months. If the stock return is above zero during that time, then the asset has positive momentum and you will see a green light next to that particular stock, and if you buy it you’ll be going with the trend. If it is below zero, it has negative momentum indicated by a red light, and if you buy then it may be a costly action.
Below a chart with a real example of Italian food company LaDoria (LD IM). It is on one of the expert buy-list. On the day indicated ‘A’, the stock price exceeded the price 6 months prior indicated ‘B’. Hence, the stock from that moment on has a positive absolute momentum.
Increase your odds to make more money by going with the trend and wait for a green light!