If you spot a good share, don't buy it

What prompts you to think of buying a new stock? It's probably a piece of news or fresh information in some form, whether about a company you already know or a name that's unfamiliar. Then you do some research -- more if it's a new name, less if you already know it, and then... my advice is: don't buy it!

Instead, watch and weight. First, put the share on a watch list, to give yourself some time before you actually purchase the shares. And then build your new position over time, weighting how much of your portfolio is invested in the share depending on its price and the level of your conviction in the share.

Watch list

The concept of a watch list is simple and familiar: keeping track of companies that you are interested in but don't yet own. Most of the online investment sites have the facility to monitor a watch list, giving you automatic news feeds about the company and an easy way of tracking share-price movements.

Having the discipline of putting shares on a watch list before you buy slows down your decision-making process. That helps to prevent you over-reacting to recent information -- and an easy mistake to make. I've just written how I'm counting the cost of rushing too quickly into Cable & Wireless Worldwide!

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Using a watch list also gives you more time to research the company. It's easy to become tired and bored analysing a company in one solid chunk of work. But if you follow a company's fortunes over a period of time, you can absorb a lot of knowledge and understanding without really trying.

Of course, making yourself wait might mean some great bargains slip by. But my hunch is that mistakes avoided outweigh bargains missed. And the more familiar you get with a company by following it, the quicker you can react, confidently and safely, when there is new information to digest.

Pound-cost averaging

When you do decide to buy, it can often make sense to start small and build your position gradually. This is rather like the concept of pound-cost averaging, usually applied to making investments in the market in general. Essentially the idea is to drip feed a fixed amount of money into the market at regular intervals, buying more shares when they are cheap and less when they are more expensive.

There are conflicting arguments whether pound-cost averaging really improves an investor's risk-adjusted returns when compared with investing a lump sum at the outset. Pound-cost averaging generally makes more sense in a volatile market such as we have today than in a bull market.

When applied on a more ad hoc basis to individual shares, pound-cost averaging has two advantages. Firstly, you can buy on the dips. It's rare that you can invest in a stock that rises relentlessly. That gives you the opportunity to increase your holding on a pullback unless, of course, there is good reason for the price drop which changes your view of the share.

Secondly, you can progressively increase your holding if your conviction in the shares increases as you get to know more about the company.

Of course this approach incurs additional dealing costs. But with low-cost internet dealing now the standard, that seems a small price to pay for the greater flexibility.

Conviction

So just what is conviction? I don't mean anything to do with the FSA's insipid efforts to put insider traders behind bars. Rather, it is conviction in the sense of how convinced you are about a share's future prospects. It is your assessment of the potential upside and the downside risk.

It's an interesting exercise to consider how strong your conviction is in each share you hold. In his excellent book Investing Against the Tide, Anthony Bolton describes how each month he would divide all his holdings into five levels of conviction: 'strong buy, 'buy', 'hold', 'reduce' and '?'. Obviously the '?' category would merit further investigation and thought.

When investing in a new company, Mr Bolton would typically make an initial investment equal to 0.5% of his total fund portfolio, increasing it in steps to 1%, 2% and 4% as his conviction grew. Those percentages apply to a large professional portfolio, but can easily be adapted to suit your own portfolio.

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