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Cramer’s draconian rule that really drives profits

Amanda Rohde | E+ | Getty Images

"I know that most of you will absolutely hate this rule," Jim Cramer said. But if you want to become a better investor, you really should follow it.

"What's this rule? Simple: never buy any stock above your cost basis, or the average price you've paid to build up your current position, unless something truly transformative has happened at the company."

In other words, if you determine $25 is your buy price, and you scale into a full position at an average price of $25, but then your stock subsequently rallies to $30, don't increase the size of your position at $30, even if you think there's more upside ahead.

Cristian Baitg | E+ | Getty Images

"This behavior feels very satisfying; I know that. You feel like the stock is going higher and you don't have enough of it, so you buy more, even if it's up big from your last purchase. I understand. But you must stop doing that. Paying up for a stock that's roaring is simply chasing, and when you chase you're likely to get hurt."

Unfortunately for Cramer, he learned this lesson the hard way. His charitable trust lost money because he bought stock above his cost basis.

"Each time, I would have a good-sized position, but when the stock started roaring, I'd feel naked. Suddenly I'd decide to buy more even at higher levels because I'd think, what the heck, this one's obviously going higher still. But almost invariably, I would purchase that last bit of stock very near a short-term top."

As a result, Cramer found himself saddled with some of his charitable trust's worst results. Instead after that short-term rally, Cramer said, upon reflection he's come to discover the right move was to sell. "I now realize, I was buying when I should have been trimming the position and getting back in at a lower level. "

There is however, an exception to Cramer's cost basis rule. "It's okay to pay a higher price for a stock if something's changed at the company that makes you believe the stock could increase dramatically."

For example; a dividend boost, a strategic acquisition and insider buying are all possibilities. In these circumstances, Cramer said it is okay to average up because a new catalyst has emerged which alters the landscape, perhaps permanently.

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However if the stock is simply rallying with the rest of the market without a specific catalyst, then Cramer's rule remains solidly in effect.

"I know it's draconian," Cramer said, "but a good investor is a disciplined investor. And my empirical research says that averaging up, Wall Street speak for buying stock at a price that's above your cost basis is dead wrong. That's why I'm now saying it's a cardinal sin to buy above your basis unless the company's made some truly dramatic changes."

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