This essay was originally published in DailyWealth Trader, a daily trading advisory. To learn more about this service, click here.
There are a bunch of clubs you want to avoid...
No one wants to be in the "mauled by a bear" club... or the "I forgot my lines on stage" club... and certainly not the "negative 80%" club.
The first two are pretty obvious. But you might not be familiar with the negative-80% club. It's one of the worst mistakes investors make in the market.
They don't realize they're joining the club when they do it... the same way no one plans to get mauled by a bear.
Instead, the only thing investors see is opportunity – and a lot of it.
Today, I'll cover what the illusion is that draws investors into this portfolio-killing club. And I'll show you how to avoid joining yourself.
Here's how the trap is set...
Folks find a stock they like that's down 80%-plus. They think, "Well, this business isn't going away anytime soon. Now that it's down so much, I can scoop shares up for cheap before it soars again."
After all, a stock that's down 80% can only fall so much further... right?
A stock that's down 80% can always fall, well, another 80% or more.
Let's use Canopy Growth (CGC) as a prime example. It's a bellwether in the cannabis industry.
The company's main operations are in Canada, accounting for 57% of revenue. But it also operates in Germany and the U.S. And it's opening up more in the U.S. As more states legalize marijuana, that will likely provide more business for Canopy.
That doesn't sound like a terrible business. But even a business with a promising future can see shares fall dramatically. That's what we've seen from Canopy in recent years.
Canopy Growth isn't a dying company... Estimates show that its revenue will triple by 2026. And Bloomberg analysts expect profit margins to go from negative 37% today to positive 45% over the same period.
That sounds like a company that has a good future. If it's down 80% and has a bright future, why not buy?
Well, there's just one problem... This kind of "bottom fishing" can lead to big losses before things get better.
Let's say you bought shares of Canopy in December hoping to call the bottom. You saw the growth ahead and wanted to profit if things go well for the company.
If you made that choice, though, you'd be down big time today. The stock has fallen another 74% over the past seven months...
That's right... If you bought back in December hoping to pin the bottom in Canopy, you'd be down nearly 80%. Since its February 2021 peak, Canopy is down 95% in total.
This is what investors miss when they go bottom fishing. They buy under the illusion that a stock down 80% can't fall much further. By doing that, they greatly underestimate their risk. All they see is the chance to strike big on a huge winner.
That doesn't have to happen to you, though. This is a problem you can easily avoid. In fact, one simple rule can help you from ever making this mistake yourself...
Instead of trying to call the bottom, wait for the uptrend to return... and let the market confirm your idea before you act.
A simple way to do this is to use the 200-day moving average (200-DMA) as your guide. It's a simple way to measure a stock's trend.
When the 200-DMA is falling, that means the trend is down and you should avoid the stock.
When the 200-DMA is rising, and the stock price is above its 200-DMA, that means the trend is in your favor.
This way, you know you are investing with the market instead of against it. And you can limit your downside risk while still getting a shot at tremendous upside potential.
Remember, a stock that's already down 80% can fall just as far after you buy it. Wait for the uptrend to return to avoid buying into a falling stock.
"Get notions of price change out of your head," Dr. David Eifrig says. Investing in underrated stocks and waiting for a rally can lead to massive returns. But if you only rely on cheap stocks for profits, you risk ruining your entire portfolio... Learn more here.
"'Buying the dips' is smart until it's deadly," Dan Ferris writes. And with no clear end in sight for today's market downtrend, many investors are focusing on finding cheap stocks with high upside potential. But history shows this strategy could lead to seismic losses... Read more here.