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The Best Strategies for How to Pick Stocks

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"Buy low, sell high!" Or so we've been told. Lots of investors have this incredible knack (which they invariably deny) for "buying high" and "selling low." It's easy to get trapped into following the psychology of the market, what with all the excitement generated by the media and the market itself. It takes a lot of guts to buy into the stock market when it's at the very bottom—first of all because you never know when you've arrived at its bottom and second because just about everything you read at the end of a bear market is full of despair and doom. On the other hand, most investors have found out through painful experience that the easiest (and worst!) time to buy stocks is when everyone is euphori-cally proclaiming the immortality of a soon-to-be-ended bull market.

Market timers and fundamental analysts have their own methods of trying to make this investment dictum come true. Even so, the rest of us who are too busy or too realistic to try calling turns in the market have not been totally left out in the cold. Although we can join in their "beat the market" games, we are far less experienced, informed, and capitalized than they are. We can buy their assistance, but often at a price that may exceed its actual value, if any. Or we can strike out on our own, despite the rough terrain of emotional hills and valleys implied above. Formula strategies are the pack mules that can help you in this journey.

A formula strategy is any predetermined plan that will "mechanically" guide your investing. One very naive such formula, for example, is to buy one share of stock every week (not recommended!). The best-known formula plan, discussed in Chapter 2, is dollar cost averaging, whereby you invest the same amount of money in an asset each regular investment period, regardless of its price.

A flexible variation of this is value averaging, a strategy I devised in 1988. The basic formula of value averaging, discussed more fully in Chapter 3, is to invest whatever is needed to make the value of your asset holdings increase by some preset amount each investment period.

Other formula strategies call for rebalancing your holdings among asset types; for example, constant-ratio plans dictate that a fixed percentage of your wealth should be held in stocks. Some more active versions of formula strategies are really more like market timing; for example, variable-ratio plans change the proportion in each asset type based on some fundamental or technical indicator (e.g., dividends, P/E ratios, short interest, etc.). Asset allocation strategies generally fall into this category. We will focus on the more passive formula strategies—dollar cost and value averaging—which are simpler and less chancey for the investor.

The first three chapters provide some basic information on formula plans, particularly dollar cost averaging and value averaging. The basic notions to grasp are that formula plans help you avoid the herd mentality and its arbitrary and often ill-timed investment shifts; they also help guide you in the general direction of buying lower and possibly selling higher. Dollar cost averaging helps a bit on the "buy low" side, but it provides no guidelines for selling. Value averaging has the effect of exaggerating purchases when the market moves lower, but buying less and sometimes even selling shares when the market moves higher. The latter is a bit more complex but well worth considering, given the added flexibility and generally higher returns. All of these issues will be analyzed at length in the chapters to follow.

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