Notice: The following is provided for informational purposes only and does not constitute investment advice. Please do your own independent research before making any investment descision. You are responsible for the choices you make and this is just some stuff you read about on the web.

Stock Swami Theory

If all your friends jumped off a cliff, would you jump, too? Probably not, at least not without a bungee cord. Yet most people do just that when it comes to the stock market. They jump on the band wagon and chase overpriced stocks only to be disappointed later when when their pretty little bubble stock pops. Following the crowd can be very disappointing and quite costly. If you owned Internet stocks in 2000, you know exactly what I'm talking about.

In theory, making money in stock market should be easy. Buy low, sell high is a guaranteed successful investment strategy and yet few people follow it. Why is that? By definition, an undervalued stock is an unpopular stock. Doing the unpopular thing is very difficult. Quite simply, human beings are a social animals and going against the crowd is often not in our best interest. Investing in unpopular stocks almost always feels wrong.

However, if you take a rational look at popular and unpopular stocks, you will see that the unpopular stocks are the ones likely to be the real money makers. Consider a mythical corporation that we'll call XYZ Corp. Let's assume that there is a lot of popular interest in the stock. The analysts all believe that great things are in this company's future. Should you invest in it? No, because the stock's price already reflects belief in the company's rosy future. The price of the stock always reflects everything that is known about the company. This concept is important to grasp.

Now, let's consider the future. The future is, of course, impossible to predict, but two outcomes are guaranteed. Either the company will live up to the investors' expecations or it will not. If it does live up to the company's expecation, the price of the stock may stay flat or rise only moderately since the stock price already reflects the high expectations of the investors. If the company fails to meet investor expectations, the price of the stock will drop in response to lowered expectation. Popular stocks don't have very much upside potential in the long run.

Now, let's assume the converse. XYZ Corporation has been mismanaged and had some bad luck. Investors and analysts now consider this stock a "dog." What are the possible outcomes for this stock? Currently the stock price is depressed because it reflects all the pessimism folks have about the company. In the future, either XYZ Corp will continue to run the company poorly or it will change its business strategies and turn itself around. The price of stock will stay flat in the first case and rise in the second case. Unpopular stocks have a great deal of upside potential and little downside since the price already reflects low expectations.

The following matrix summarizes the News vs Expectations Outcomes:

We see now that stocks with low expectations have the greatest potential for performing well in the market.

Continue to part two...