It’s important to make sure the cheapest stocks to buy are truly value stocks

It’s typically better to buy stocks when prices are down, not up. This rule applies to the most undervalued stocks on the market, just as it does to most stocks.

However, the cheapest stocks to buy are not always value stocks.

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Are the cheapest stocks to buy safe?

You have to learn a lot of things to become a successful investor, and few people learn them all in any logical progression. Instead, most of us move from one subject of interest to another, with a lot of zigs and zags in between.

That’s why some investors go through a phase when they know just enough about a particular investment to be a danger to themselves and others.

All investments come with a mix of risk and potential reward. The greatest danger comes when you understand the mechanics of an investment, but you’re missing some of the details. Your understanding of the potential reward can make you greedy, while the gaps in your knowledge limit your natural, healthy sense of skepticism.

Promoters of speculative systems exploit this all-too-human failing in their advertising.

What to do when you think you have found the cheapest stocks to buy

When you find what you feel are the most undervalued stocks, but think there is a chance they may go lower, consider investing at least some of your funds by practicing “dollar cost averaging.” Invest the same dollar amount on a regular basis. That way you’ll buy more shares when prices are low, and fewer when they’re high.

Using a dollar-cost averaging strategy helps build consistent long-term investing returns. Long-term studies show that the stock market as a whole generally produces total pre-tax annual returns of 8% to 10%, or around 6% after inflation. Over periods of a few years or less, the return is far more variable and always uncertain. The surest way around this uncertainty is to start practicing dollar-cost averaging as early as possible, and invest regularly over the course of your working years. Then you can sell gradually in retirement.

The cheapest stocks to buy can leave you open to a double risk

Seemingly attractive stocks can drop for months, or even years, before a hidden flaw comes to the surface and explains their weakness.

For that matter, little-noticed stocks sometimes rise for months before the reason for their strength becomes apparent. In a lifetime of investing, you’ll choose both kinds of stocks.

If you always try to buy below the market, you’ll always get a “fill” on stocks with hidden flaws. They’ll always come down into your buying range ….and they’ll keep on falling.

But you’ll never get to buy the other kind of stock—the kind that keeps going up. These stocks will always seem too expensive, and they’ll go on to get even more expensive. But you need a few of these ever-more expensive stocks to offset the losses from those that get cheaper and cheaper.

There’s no easy answer to the buy-now-or-wait dilemma. At times it may pay to hold off—for instance, a company’s stock will often rise when it announces a stock split, then fall after the split takes effect.

In the end, if a stock is truly worth investing in, you should be willing to buy it at current prices, even if that means you run the risk of having to sit through a 5% to 10% setback. Before it slips into its next 5% to 10% setback, after all, it may first go up 50% to 100%.

How to find undervalued stocks using your brain, not your emotions

One of the sweetest and most profitable pleasures of successful investing is to buy high-quality “value stocks” (or stocks that are reasonably priced, if not cheap, in relation to its sales, earnings or assets), then hold on to them as investors recognize the value and push up the share price.

Value stocks are typically stocks trading lower than their financial fundamentals suggest. They are perceived as undervalued, and have the potential to rise.

When they look for value stocks to buy, investors usually start by looking at a few basic ratios. For example:

• Low price-to-earnings and price-to-book ratios—signs of cheap or undervalued investments.
• Low price-to-book-value ratio—another sign that stock is cheap in relation to other stocks on the market.
• High dividend yield—the stock’s annual dividend divided by the share price. A high dividend yield could indicate a cheap stock that is set to rise.

Do you look for the cheapest stocks to buy, or are you skeptical of cheap stocks? Do you feel that cheap stocks could lead to significant investment success for you? If you do buy any cheap stocks, what draws you to do so? Please share your thoughts with us in the comments.