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One Simple Rule for Deciding Whether to Buy After a Stock’s Price Has Skyrocketed

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One Simple Rule for Deciding Whether to Buy After a Stock’s Price Has SkyrocketedThe key stock indices in the U.S. have gone up significantly since the beginning of the year and continue to make new highs. Consider the S&P 500: from opening on the first trading day in 2013 to close on Friday, May 24, this key stock index is up almost 16%. But the S&P 500 is not the only equities index in uncharted territory; the Dow Jones Industrial Average and the Russell 2000 are doing the same. Other key stock indices, like the NASDAQ Composite Index, are also trading at multiyear highs.

While the returns registered by the key stock indices are impressive for such a short period of time, some of the big-cap stocks have done much better. Look at the stock price of Best Buy Co., Inc. (NYSE/BBY), for example. Since the start of the year, the stock price has soared from trading at $12.00 to currently above $26.00, gaining almost 117%—seven-times better than the performance of the S&P 500. The chart below depicts the outstanding price action in Best Buy’s stock prices:

Best Buy Inc Chart

Chart courtesy of www.StockCharts.com

Other companies have shown a decent rise compared to the key stock indices as well; Hewlett-Packard Company (NYSE/HPQ) is a good example, as seen in the chart below:

Hewlett-Packard Co Chart

Chart courtesy of www.StockCharts.com

Hewlett-Packard’s shares traded close to $15.00 in the beginning of 2013 and are now above $24.00. This rise in the stock price represents an increase of 60%, or 3.75-times better than the performance of the S&P 500.

Looking at returns like these, investors often start to get the feeling they’re missing out on the gains, and they end up buying companies that have risen significantly. Note that Best Buy and Hewlett-Packard are just two examples.

It is certainly true that the stock prices of companies that have gone up significantly can go even higher, but investors who are focused on investing for long periods of time shouldn’t just focus on how much the price has increased. They must consider the value of the company before making any sort of investment decision, be it buying or shorting.

There have been many instances in the past when investors drove the price of a stock higher, only to later realize they valued it too high. As a result, there was a steep sell-off in stock prices, and those who got in late were faced with losses. The tech boom was the prime example of this scenario: investors were investing in companies that didn’t even earn any revenues, or they were pricing companies at a much higher earnings ratio than they deserved.

By no means does this suggest that the stocks mentioned above can’t go higher. When investors are faced with this sort of scenario and feel they have missed out on big gains, they should keep the risks in mind. To further rationalize their decision besides considering just the price gain, investors should look for the reason for that gain; if the stock’s price increased without a reason, investors should remain skeptical and not act until they know the exact cause.

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