3 Trading Patterns That Don't Work

We're all looking for secret formulas to make our lives easier. If you only knew the best kinds of stocks to buy, or the best times to buy them! Well, researchers Brad Barber, Terrance Odean, and Michal Strahilevitz can help you narrow down your choices -- by pointing out three common trading strategies you're better off avoiding.

In a 2004 paper, they studied the trading records of hundreds of thousands of investors at a major brokerage, identifying three commonly preferred trading strategies that often yielded unhappy results:

• Repurchasing stocks that investors sold before at a gain.
• Repurchasing stocks that have fallen in value after investors sold them.
• Purchasing more shares of stocks that have fallen in value after being purchased.

I suspect those patterns will sound familiar; they seem like sensible things to do. If a stock made money for you before, you may fondly expect it to perform again -- even if it's no longer the bargain it once was, or if its competitive position or overall health has weakened.

If a stock has fallen since you sold it, you may think that it's likely to rebound to previous levels. Again, you may be lured by your familiarity with the stock, assuming that if it falls, it's automatically more of a bargain. Alas, that's not always the case.

And if a stock you bought has fallen, you may want to lower your average cost basis, in the belief that it's more undervalued now. However, stocks can fall for good reason, and not all of them recover.

The following companies have fallen significantly in the past year, making them prime candidates for purchases or repurchases by people who think their tumble automatically makes them bargains:

Data: Motley Fool CAPS.

Some may indeed be excellent buys. Apollo Group performed spectacularly during 2008's bear market, and it's a Motley Fool Inside Value recommendation. But that won't hold true for every stock on this list; fellow Fool Rich Smith recently panned Palm's prospects.

Breaking the pattern
Before you buy, separate each stock from its past price. Compare its price today to your estimate of a fair value for the stock, and factor in the company's growth prospects going forward. Don't worry about whether you bought it before and how it did.

Through their research, Barber, Odean, and Strahilevitz found that "[i]nvestor returns do not reliably benefit from any of the three patterns we document." Don't make the mistakes their study uncovered. The future, not the past, should be your guide.