Written by CNBC Posted On: Monday, 20 August 2012
Investors can avoid some of the most common and money-losing mistakes in any environment by following five easy rules, "Mad Money" host Jim Cramer said Friday.
"If you follow my rules, you should be able to recognize an opportunity when you see it and to manage to avoid losing money when you don't have to, no matter what the circumstances, including a collapse in Europe or a slowing in China or even a skyrocketing oil price," he said.
Rule No. 1: "Don't dig in your heels when you're wrong"
The late, great economist John Maynard Keynes always said, "When the facts change, I change my mind." Cramer has adopted the quote as his personal mantra. After all, he said one of the easiest mistakes to make is refusing to change your mind when the facts are in and you've been proven wrong. It's one of the most difficult things for the most emotional investors and traders to do, but also crucial to be a good investor.
"Swallowing your pride is never easy, but the more time you spend digging in your heels, the less you have to take advantage of the new situation and profit from it," Cramer explained.
Rule No. 2: "Price matters"
Price is so important, that if it could go low enough, investors are willing to buy stocks of companies they don't even like that much. Cramer will never recommend a stock when he thinks the fundamentals of the underlying company are deteriorating and normally there's a lot of space between a "best of breed" company and one that's uninvestable. In normal circumstances then, if a lowly company's stock falls to a certain level that makes it just too darned cheap to pass up, Cramer thinks it's perfectly OK to buy when you merely have a low opinion of the underlying company. That's when price matters.
So how do you know when the price is right for a stock you wouldn't otherwise buy? It's a sliding scale, Cramer said, where the better the company, the more you should be willing to pay. If speculating, he recommends looking for companies that have been left for dead, even though they still have pulse upon closer inspection. Just be sure that bankruptcy is not on the table, he added. So long as bankruptcy is not on the radar, then buying an unattractive company at an attractive price could make a lot of sense.
Rule No. 3: "Don't take your cue from an inferior company"
When a "worst of breed" name says things are bad for the entire sector, don't just take it on faith, Cramer said. Weak players always seek to pin their failings on the entire industry, he explained. It's important, then, that investors are able to recognize the excuses.
If a company has gotten into the habit of serial underperformance and blames its shoddy results on a shoddy environment, Cramer said the odds are that its competitors will tell a different story. At the same time, bad news for one company might not mean bad news for another company in the same sector. Investors can't just assume that all companies in the same industry are equivalent, he noted.
Rule No. 4: "Don't believe the hype"
Not all upside surprises are worth getting excited about, Cramer said. If a company reports quarterly results that show its earnings-per-share are higher than what the average analyst on Wall Street had expected, then all of the headlines will describe it as an upside surprise.
"Stocks are supposed to go up when the underlying companies they're attached to deliver higher earnings than anyone had expected," Cramer explained. "But what the headlines call an upside surprise and what truly impresses the professionals in a quarter are two different things."
Headline writers don't draw a distinction between a high quality upside surprise and a "low quality, illusory" upside surprise, Cramer noted. Investors can tell the difference, though. A high-quality upside surprise is generated by high-than-expected sales, which leads to better-than-expected earnings per share. Improved sales means the industry is improving and more people are buying the company's products or it could mean that the company is taking market share. Either way, it bodes well for the company.
On the other than, a low-quality upside surprise is based purely on a better bottom line (earnings per share) than the top line (the sales number). In this case, the upside surprise is not generated by improved business, but because management cut costs, changed their accounting practices or bought back shares. None of these things matter to Wall Street analysts, though. Instead, they want to see a company's ability to deliver better-than-expected sales.
Rule No. 5: "Be critical of commentary"
One of the most natural and misleading mistakes, Cramer said, is to assume that people on TV criticizing the market must be telling the truth. Don't fall victim to this. People who dislike the market are not any more honest or less self-interested than those who talk up the market and/or individual stocks.
Investors should be just as skeptical of bears as they are of bulls. But to most people, expressing a critical view of the market and/or an individual stock automatically bolsters the commentators credibility. But Cramer said the people criticizing the market in the media aren't necessarily trying to help you.
When people see a commentator recommending a stock, they automatically assume that person owns it and is promoting it for those reasons. But nobody thinks the commentator criticizing the market is just trying to knock stocks down in order to buy them at a lower price.
The rule of thumb is to always be on your guard and think critically of what you hear the commentators say on TV or read in print, Cramer said. After all, the bearish commentators aren't any more altruistic or honest than the bullish ones.
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