With thousands of publicly traded companies out there, it can be overwhelming trying to figure out which stocks to buy.
Now add in a constantly changing market.
Between understanding what makes a good stock to buy and when is a good time to buy it, many investors end up frustrated or confused as to what they should do.
One way to alleviate this stress -- follow some simple rules. It's worked very well for me and readers of my premium newsletter, Alpha Trader.
Our system focuses on stocks outperforming the market today, which tend to continue beating the market in the months that follow. That's been proven in academic journals, and it's something I've talked about several times (here, and here).
But that's only half the story. Below are a handful of closed trades that significantly outpaced the market while we held them. While these stocks performed well, it's not why I bring them up...
|Stock||Total Return||S&P 500|
|Hi-Crush Partners LP (NYSE: HCLP)||66.1%||22.0%||+44.1%|
|Bank of Ireland (NYSE: IRE)||60.5%||12.8%||+47.7%|
|Amkor Technology (Nasdaq: AMKR)||57.7%||4.8%||+52.9%|
|Arris Enterprises (Nasdaq: ARRS)||47.4%||12.7%||+34.7%|
|Helmerich & Payne (NYSE: HP)||38.1%||15.7%||+22.4%|
These Alpha Trader stocks gained 40.4% more on average than the S&P 500 while we held them. It's clear that the system did a great job of identifying stocks ready to move higher. What is less obvious -- and something traders rarely think about -- is whether the system made the right call to sell them. To me, that is just as important, or more so, than picking the right time to buy.
Here's what happened to those five stocks after the system gave a sell signal...
|Stock||Total Return||S&P 500|
|Hi-Crush Partners LP (NYSE: HCLP)||-1.7%||1.3%||-3.0%|
|Bank of Ireland (NYSE: IRE)||-20.1%||6.8%||-26.9%|
|Amkor Technology (Nasdaq: AMKR)||-34.6%||3.1%||-37.7%|
|Arris Enterprises (Nasdaq: ARRS)||-4.6%||-0.2%||-4.4%|
|Helmerich & Payne (NYSE: HP)||-16.1%||-0.2%||-15.9%|
These big winners have underperformed the market by an average of 17.6 percentage points since we sold them. This isn't a large enough sample size to make any definitive conclusions, so I went back and analyzed all 184 closed positions and calculated the average return on these positions after we sold them.
Not surprisingly, the average return post-sale was a slight gain of 0.2%. By comparison, the average return on the S&P 500 over the time these stocks were held was 6.1%. That's a huge, statistically significant difference.
It tells us that stocks we sold lagged the market after the system tagged them as sells. This is a stark contrast to what the average investor experiences. Research from 1997 by Terrance Odean shows that the stocks investors sold actually outperformed the stocks investors held by roughly 3.4 percentage points in the 12 months following their sale.
Think about that...
Considering that the average individual investor generated annualized returns of 2.1% from 1992 to 2012, that 3.4% difference could be a life changer for many of them.
That's why it's crucial for traders to have selling discipline. For us, that means selling when stocks are losing momentum, or more specifically, when relative strength (RS) falls below 70. If you've heard about Alpha Trader in the past, you understand why it makes perfect sense that the stocks we sell underperform the market.
If the stocks with strong momentum outperform the market, then stocks with lower momentum should underperform the market. And that's exactly what our data shows.
Amkor Technology (NASDAQ: AMKR) is a perfect example of momentum in practice...
We bought Amkor on Feb. 26 and held it for approximately six months until the system gave a sell signal on Aug. 12. We rode this stock higher and locked in a 57.7% gain when we sold.
This gain was followed by a subsequent pullback in the stock to the tune of 34.6%. It is this kind of performance swing that the Alpha Trader sell rules have been designed to protect us against, and in this case, the system protected us perfectly.
Of course, not every trade we close will be a winner, but that doesn't mean the system's sell rules won't still protect us.
The emotion involved with buying and selling can cloud judgment. But when you follow a strict set of rules, you don't have to worry about when to buy or sell.
Last week, the system triggered sells on five stocks -- four are in the green and two are showing 20%-plus gains as I write this. The system also signaled two new buys. One of the buys is a dirt-cheap semiconductor company, the other is an auto parts maker based in one of the fastest growing new car markets in the world. Though the companies are very different, they've both popped up on my radar based on the Alpha Trader buy signal. To learn more about Alpha Trader and how we've used the system to bag 114% and even 242% returns in less than a year, click here.
This article was originally published on StreetAuthority.com: Don't Ignore The Indicator That Could Revamp Your Investments