Eight Tips Based on How the Stock Market Actually Works

“How the Market ACTUALLY Works”—what does that mean?  

Simply that so much of the advice and so-called facts that you hear on TV and read about in financial magazines is basically nonsense. I found that out the hard way—by losing money!

Over the years, however, I became a veteran student of the market, using market history and observation to discover how the market actually works…as opposed to how many investors think it works. Nothing below is revolutionary, but it’s good to remind yourself of the basics to stay on a path to profits.

So, here are some things to always keep in mind:

Price doesn’t matter: The price of a stock is NOT a predictor of success. So if you’re eliminating higher-priced stocks from your buy lists, you’re eliminating many potential winners. The fact is, no institutional investor avoids high-priced stocks, and it doesn’t matter if you own 10 shares or 100 shares. All that matters is how much MONEY you’ve invested. Personally, I rarely buy in round lots, instead buying a set dollar amount.

For growth stocks, valuation is a result of performance, not the cause of it: P/E ratios get lots of attention, but the fact is they’ve proven to have little predictive value either for an individual growth stock, or for the market as a whole. Believe it! Other factors–such as sales growth, earnings growth, sponsorship and potential for continuing upside surprises–are far more important. Historically, the biggest winning stocks have always begun their runs with huge P/E ratios.

Don’t get too concerned by insider selling: Like P/E ratios, insider selling elicits big emotions from many investors. After all, if the top brass is selling, why should you sit tight? But in reality, things aren’t that clear cut. First, management might be selling some shares, but getting more in options or future compensation. And second, big-winning growth stocks are usually entrepreneurial … so these people may have worked there for years and have a chance to cash in some of their shares. Either way, there hasn’t been any strong correlation between insider selling and future performance; sometimes it marks tops, but oftentimes it doesn’t.

Strength begets strength … to a point: Too many investors fall into the trap of looking for the stock that hasn’t yet advanced, thinking it’s “due” to “catch up” to its peers. Most of the time, that’s an error—you want to invest in the leaders, which are usually the first stocks in a group (or the entire market) to hit new peaks. Of course, you don’t want to buy a stock that’s been soaring for six months in a row and is very extended; that’s where chart reading comes into play. Ideally, you’re buying a stock that has consolidated for a couple of months and has just broken out to new peaks.

Trailing stops are nice … but do the math: Most investors I correspond with like to use a pre-determined trailing stop, say, 20% down from a stock’s peak. Thus, you’ll never lose more than 20% off a stock’s high—but realize that 20% is a lot! For instance, if you only sell using this method, just to break even you’re going to have to pick a stock that first rises 25%. And to make 50% on your investment, a stock must first rise 88%! Thus, it’s usually better to sell some shares offensively (on the way up in price) while using a trailing stop for the rest of your shares, giving yourself a chance at a home run.

Stock splits tend to be negative, not positive: Yes, sometimes a growth stock will pop on a stock split announcement, but you should know that many of the best stocks will top out on or soon after a split … especially if it’s the stock’s second or third split in a year or two. So if you’ve got a big winner you’ve ridden for months, and it pops on a split announcement, you should consider selling some.

Sales growth is often more important than earnings growth: There are many ways a firm can boost earnings, including cost cuts, layoffs and higher productivity. But there’s only one way to grow revenue—and that’s to sell more! Thus, excluding acquisitions, if you find a company consistently growing at 50% or more (100% or more is even better), you’re likely looking at a firm with a unique product or service … and a stock that could do very well. (Historically, our top stock-picking tool has been triple-digit revenue growth.)

The market tells its own story best: You shouldn’t pay much attention to predictions of where the market’s heading, or why it’s going to do such-and-such because of the U.S. dollar, commodities or China’s actions. Remember that the market itself tells its own story best—so stay focused on the action of the indexes and of leading stocks. They’ll give you the most accurate indication of what comes next.

These tips should kick your portfolio off to a good start!

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