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Why investing in cheap stocks isn't always a bargain

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When the market falls heavily like it has over the past few weeks, it is very common for investors to want to get into stocks for two reasons.

The first is their emotions, as many are controlled by the fear of missing out, although in the current market conditions, it would be wise to be patient.

The second reason investors want to buy in is because they believe stocks are cheap given how far they have fallen. But what is a cheap stock?

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Cheap implies that you will get a bargain, which may be the case when you go to the supermarket, but it is not the best mindset or strategy to adopt when investing in the stock market, as it can cost you a lot of money.

Is a stock that is falling in value cheap? Maybe, provided it doesn't continue to fall once you purchase it. Is a stock trading under $5 cheap? Maybe but you have to ask, cheap in comparison to what? Is a stock that is trading under $1 good value? Possibly, although many of these stocks are referred to as "penny dreadful" stocks and for good reason.

While it is easy to compare two items at the supermarket to determine whether you are getting a bargain, you cannot do the same when it comes to comparing stocks, as price alone does not imply that it is cheap or expensive. A stock is only cheap or expensive in comparison to the real value of the asset, not just the price of the share at any one point in time.

I have lost count of the number of people who have told me they invested in a stock because it was cheap. When I ask why, they tell me they can buy more shares in a stock that is trading at $0.50 than they could buy if a stock was trading at $20. But it's important to understand that the amount of shares you own is irrelevant to your potential profit. Let me explain.

If I have $1000 to invest, I can purchase 2000 shares at $0.50 or 50 shares at $20. If the shares rise by 10%, do I make more money on the $1000 invested in the $0.50 shares compared to the $20 shares. The result is exactly the same, although it is highly likely that a $20 blue chip stock has more potential to rise by 10% than the $0.50 stock, and is far less likely to fall heavily in price.

While there is always the temptation to buy shares that have fallen heavily, when investors buy cheap stocks trying to get a good buy, they usually end up saying goodbye to their money. So now is not the time to be buying and contrary to what you may be thinking, there will be plenty of time to profit once the market confirms it has stopped falling.

Best and worst performing sectors

With so much going on over the past few weeks, it has felt like time has moved much slower than normal. I know I have said in the past that a week can be a long time in the stock market given that last week everything was falling heavily, yet this week it has been the opposite.

Industrials is leading the way up more than 12%, followed by Healthcare and Information Technology, both of which are up more than 11% so far this week. Currently, only two sectors are in the red with Consumer Staples down just more than 1%, while Utilities is down just under 1%. Consumer Services is also near the bottom of the list up more than 2%.

Looking at the ASX top 100 stocks, we would normally be quite happy to see stocks up a few per cent on the previous week yet as of writing, more than 25% of the top 100 stocks have risen more than 10% for the week.

Surprisingly, Qantas is leading the charge up more than 37%, while Sydney Airport is up more than 25% and Santos is up more than 24% so far this week. It is not as bad as previous weeks for the worst performers given that only the Bank of Queensland has fallen more than 10%f this week while Flight Centre has been in a trading halt. Vicinity Centres and JB Hifi were also both down more than 6%.

What's next for the Australian share market

On Monday the stock market fell to 4429.12 points making the current crash 22 days long and the fall 39% from the February 20 high.

From the open on Monday of this week, the market is currently trading around 6% higher after three days of sustained rises, and investors are now asking if we have seen the bottom. Remember, it is normal for the market to bounce and retest prior highs and last week I mentioned that we should see this occur any day now and for this to last weeks.

It is foolhardy to jump into a volatile market that has only risen for a few days after falling so heavily; in fact, it is very dangerous. As I said previously, right now, investors need to be patient as there will be plenty of time to buy into good stocks. What is likely to unfold is that we will see a short rise over the next one to four weeks before the market falls away to test the prior low. While nothing is certain, it is dangerous over the next month to attempt to bottom pick perceived cheap stocks trying to grab a bargain.

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Dale Gillham is chief analyst for Wealth Within (AFSL 226347). He has an Advanced Diploma and Diploma of Share Trading and Investment and more than 25 years' experience in the financial services industry.
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