Know Why You Bought Before You Start Selling

Alas, again, we have to go through the bottoming process and the psychology that comes from an uncertain economic and geopolitical environment. Throw into the mix the fear and anxiety generated each day by a new case of anthrax, and you get an environment that's ripe for profit-taking. Over the past three weeks, most stocks have quickly moved from an extreme case of oversold to a high level of overbought.

Since the Sept. 11 attacks, I've tried to emphasize the importance of determining your time frame and risk-tolerance level before buying a stock. Establishing a clear-cut strategy before you trade can help remove emotion and enable you to make the proper decision. If you bought the market or a stock recently because you thought the action was overdone to the downside, you're likely a more short-term-oriented buyer. If you bought the market or a stock because you thought values were attractive and you liked the longer-term outlook for the economy and business given the unprecedented level of interest-rate cuts and fiscal-stimulus packages, then you're probably an investor.

Why is this distinction so important?

If you don't know why you bought, how would you know why and when to sell? All too often, we buy a stock thinking that it's about to make a big move higher because of a recent decline. When it doesn't, we justify our position by saying that it's a good company and will eventually come back. On the other hand, when we buy a stock because of its long-term fundamental story, we sell it if it quickly rises, believing that locking in a profit is never a bad thing.

These are common mistakes that most of us have made more than once. In the first case, we made a trade into an investment, and in the second case, we made an investment into a trade. Two of the biggest mistakes anyone can make are to hold a losing position in the hope of someday breaking even, and to cut winners too quickly. It is the absolute reverse of what we should do to be successful over the long term.

Short-Term Outlook

Many people bought stocks when the markets reopened on Sept. 17 due to the severe decline in equity prices. The psychology? A snapback would occur when traders realized that stock-price declines were overdone, as the market was basically in an organized free fall without any overhead resistance in sight. In hindsight, that was the proper decision.

The key question now: Is that reason for buying still valid? The answer is no. All major market indices are up by well over 10%, with high-tech and telecommunications stocks seeing the largest reflex rallies. Not only is the market no longer oversold, but also is actually overbought and near key resistance

Time Out for the S&P 500 This index is now very overbought and in need of a rest.

Source: Baseline

Does that mean stocks are poised to go down big and potentially retest the lows? Probably not. Either way, it doesn't matter. Your reason for buying is no longer valid. If you have this time frame and line of reasoning, you shouldn't justify holding your positions by citing new reasons such as earnings and interest rates. You bought for a bounce-back and got it, so move on to the next trade.

Longer-Term Outlook

Not everyone bought stocks for a trade when the markets reopened Sept. 17. Many saw much more attractive levels of valuations, especially given the backdrop of low inflation, declining interest rates and the unprecedented level of potential fiscal stimulus geared toward economic improvement. Yes, stocks were down big, but a reflex rally wasn't why these folks were buyers.

Any time you look to sell a position, ask whether your reasons for buying are still valid. Despite the solid gains of the past three weeks, the answer still seems to be yes. Inflation should remain subdued for the foreseeable future. The Federal Open Market Committee stands ready to ease again at its next meeting. Congress is debating an economic stimulus package and should enact it by year-end. The markets are bouncing from oversold levels, near support, and are beginning to gain momentum.

A Long-Term Outlook The S&P 500 remains near oversold territory, but is gaining momentum

Source: Baseline

If your reasons for buying haven't changed, your positioning shouldn't, either -- even considering recent stock-price gains.

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