Folks -- I'm preparing an article citing this response to an article I write last month, and I wanted to make the entire response accessible. Here it is. Look for the article around Friday.

Selena
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Regarding Selena Maranjian's November 5th Article “10 Big Investing Mistakes” (http://www.fool.com/news/commentary/2004/commentary04110502.... )

A Response From Investor's Business Daily

The biggest mistakes many investors make tend to be strategies that seem like common sense. Buy low sell high? Sounds great. Average down to get a bargain on a falling leader? Who doesn't like buying at a discount? The problem is that the stock market doesn't work according to common sense. If anything, it tends to do the exact opposite of what the average person might think. Time and again, market cycle after cycle, research proves that these supposed “common sense” strategies have little to do with the realities of the market.
Are there exceptions? Sure there are. But after the last bear market, you can't count on exceptions. When 80 million people lose around 7 trillion dollars, we don't like to talk about exceptions. We talk about facts—and the facts prove these are mistakes to avoid.

1. Buying stocks according to their P-E ratio:

Our stock market studies from 1952 to present show that P-E ratios were not a relevant factor in price movement. From 1953 through 1985 the average P-E ratio for the best-performing stocks at their early emerging stage was 20, which value investors might consider high. While advancing, the biggest winners expanded their P-E's by 125% to about 45. During the 1990-95 period, the real leaders began with an average P-E of 36 and expanded into the 80's. Stocks with “high” P/E ratios share a common trait: their performance shows there's plenty of bullishness about the company's future prospects. Example: In August of 2003, stun-gun maker Taser International had a P/E of 44 before a 900% increase. At the time, the market was bullish about the firm's earnings and sales growth prospects. The market turned out to be right. For five straight quarters, Taser has posted triple-digit earnings and sales gains.

Think of it this way: if you want Michael Jordan on your team, you have to be willing to pay for it. So looking for a stock with low P-E's is not going to help you find a winner. However, a high P-E in and of itself is not an indicator of a potential stock market winner. Research shows that great stocks possess 7 common performance traits prior to major moves, earnings being one out of 7 key factors.

2. Not cutting losses short

No offense is good without a sound defense. It is true that a stock will go through normal corrections in price. But the 7% sell rule is designed to help safeguard against losses when you may be wrong about a stock as opposed to a mild correction in a winning stock. A stock purchased at the proper time in a good market, with all the common performance traits great stocks have exhibited, will typically not drop radically in price. If there is a major market turn, the 7% rule will protect you. We found that investors who followed this rule were able to avoid severe damage to their portfolios during the bear market that began in March 2000.

What can you do to protect yourself? You must have a realistic plan of selling and taking profits on the way up, while a stock is still advancing, and selling and cutting losses very short when a stock starts off poorly and goes against you. Specifically: you should consider taking most profits at 20% to 25% and cutting all losses at 7% or 8%. The sell-price profit target, in other words, is roughly three times the loss-recognition point. This way, you can be right on only 30% of your stock purchases and wrong on 70% and still not get into serious trouble.

3. Buying stocks in a down market

This is perhaps one of the biggest mistakes investors tend to make. Often, they will have the opinion that with stocks declining in a bad market, it's a great time to scoop up bargains. It's very hard to make money in a stock when institutional investors are selling that same stock. IBD's factual analysis of every market cycle going back for decades shows there is no room for opinion in this area: 3 out of 4 stocks follow the market's direction. Period. Why take that chance?
Does this mean you should sit out a bad market and do nothing? Absolutely not! A down market is the perfect time not to look for bargains, but to look for emerging leaders: the next Microsofts, Ciscos, Home Depots and others that are going to skyrocket when the market turns. In a weak market, a smart investor recognizes the risks, stays alert and looks for emerging strength in stocks that will jump when the market turns.

4. Averaging down

This is exactly why so many people lost money in the 2000-2003 market. Just ask anyone who scooped up shares of former leaders like Lucent, Enron, Worldcom, AOL and others with glee only to see them hit rock bottom as the market sold off. It is very common for investors to look at a falling stock and assume its drop is temporary. Look at the glowing fundamentals, they'll say. Look at the popularity of its products. But history shows that stocks falling in price on increasingly higher volume almost always continue to fall in price. If you see a stock dropping in above-average volume for consecutive days in a row, this means the big institutions are dumping shares: a bad sign.

For example, take Amazon.com between June and October of 2004. Its chart revealed much institutional selling by mutual funds and other big investors. In June, it was a $54 stock. In July, it was a $45 stock. Investors who bought in at $45 may have thought they were getting a bargain, but they weren't paying attention to multiple heavy-volume declines in the stock. What's the sense of buying a stock when mutual funds and other big investors are selling big blocks of shares? That's a tough tide to swim against.

When Amazon released earnings on Oct. 21, it fell another 10% to around $37. In general, stock charts tell bullish or bearish stories long before headlines do. In Amazon's case, heavy volume declines between July 8 and July 23 told a bearish story.

5. Buying stocks because they pay a dividend

There's nothing wrong with owning a stock that pays a dividend. But hanging on to a stock or buying a stock just because it pays a dividend is a mistake. There is no comparison between the profit you make from a dividend and the profit you can make in a winning growth stock that has the potential to make 100%, 500% or even 1,000% return, or more. High performing growth companies will typically not issue dividends. Rather, they will reinvest their capital into research and development (R&D). The bottom line is that smart investors don't look for dividends from stocks, they look for winning stocks that will generate high returns.

6. Buying in rumors, tips, opinions.

The easiest way to lose money in stocks is to base your decisions on what you hear from friends, magazines, TV, radio, newsletters or your Uncle Joe with the “hot tip.” The stock market is not a casino: chance does not apply. So never follow the herd in the stock market, only follow the market itself. It will tell you everything you need to know to succeed through patterns of stock behavior that have maintained in the market for decades.

7. Avoiding stocks at new highs

Stocks making new highs tend to go higher. That's why, rather than “buy low and sell high,” you should “buy high and sell higher.” Now, does that mean you should only buy stocks that hit a 52-week high? Absolutely not! Instead, this is one ingredient in many you want in place before buying a stock. There is an ideal pivot, or buy point, at which a stock is gaining substantial institutional support. That support is what will continue to move that stock upward and onward. A stock moving down in price is a losing proposition. Growth investing calls for buying into strength and selling into weakness, and growth investing has proven to be the best investing strategy in a strong market. (IBD's CAN SLIM growth strategy was the most consistent performer among over 50 other well-known strategies over a 5 year period, gaining 704.9% from 1997—2003, AAII independent studies).

8. Staying married to a stock.

While you can get away with holding onto stocks through a mild bear market, doing the same thing through a severe downtrend can be devastating. Three-fourths of all stocks fall during a major downtrend but not all recover. For instance, 72% of past leaders in the recent bear market did not recover to their old highs. And some are so severely impacted by the fall that you end up with damaged merchandise that may rise again but never see its old highs. That's why a smart investor is always ready to sell when the general market changes.
Coca-Cola was a stock a lot of people held onto like a dear friend. They thought of it as a classic “long term” investment. In 1998 it stopped working though. It got stuck in a major downtrend that the 2000 bear market only exacerbated. Since then, “long term” investors have spent over four years biting their fingernails waiting for the stock price to rise. And that's not all: they missed out on dozens of emerging market stars. You can learn to recognize these emerging leaders by their performance numbers, rather than relying on household names.

9. Over-diversifying the portfolio

Advisers and pundits often tout the protection of diversifying one's portfolio. Yes, the more you diversify the less risk you have in any one stock. But you're still not protected against substantial losses, and you've also probably guaranteed mediocre results. Owning too many stocks can lead to a profit/loss tug of war where some stocks do well, some don't, and in the end, little is achieved. Most importantly, having to watch too many stocks makes it difficult to follow your portfolio accurately. It's better to own a few great stocks on which you can focus your time and research.

10. Buying low priced stocks

Institutional investors account for about 70% of the trading volume each day on the exchanges, so it's a good idea to fish in the same pond they fish. Stocks priced at $1, $2, or $3 a share are not on the radar screens of institutional investors. Many of these stocks are thinly traded so it's hard for mutual funds to buy and sell big volume shares.

Remember: Cheap stocks are cheap for a reason. Stocks sell for what they're worth. In many cases, investors that try to grab stocks on the cheap don't even realize that they're buying a company that's mired in problems with no institutional sponsorship, slowing earnings and sales growth and shrinking market share.