This bear market tip can be very effective if you do it the right way

People who watch the market very closely tend to take action. They become bored and restless and want to do something even when conditions are not favorable. This tendency leads to the most common advice in a bear market: to build positions by averaging into them.

In theory, this is a great idea. No one can measure the market with great accuracy, so a good way to build a position is to make smaller purchases over a longer period of time and hopefully end up with a pretty good average entry price.

There is no disputing the wisdom of gradually entering positions, especially in a weak market, but executing this strategy can be challenging. The most common mistake is to average in a position that is too big and too fast. When positions are too large in a weak market, there is an increased risk of panic selling.

The problem is that market participants tend to have a very strong tendency to act prematurely. They want to act and they also want to try to spot the exact dips, and the combination of the two tendencies is that they act too early.

Better to buy late than early

In previous columns, I have discussed my view that buying late rather than early is better. If you buy after a bottom has occurred, there are precise support levels and there is more likely to be sustained upward momentum. When you get in the teeth of a decline, you have to hope that the downward momentum is about to stop and reverse. When the market is oversold, there can be some good countertrend bounces, but it is extremely difficult to predict market declines in the future.

Averaging in bear market positions probably causes more significant damage to accounts than anything else. The big danger is that the timing is wrong and the position becomes uncomfortably large and refuses to bounce. This evokes strong emotions and causes panic reactions.

It is also essential to realize that there is a risk that you may be betting on the wrong stocks. Not every stock that sinks into a bear market will recover when conditions improve. If you keep adding while it’s going down, you’re setting yourself up for a big loss. This is another reason why it is important to look for some strength before adding to a position.

I’m a big fan of the incremental approach to trading and investing, but too many people do it wrong. They are too focused on buying weakness and trying to bottom out. You have to be willing to add strength, not just weakness. People tend to want to buy weakness because there is the illusion that they are getting a bargain, but in investing you make the big money not by buying low, but by buying a sustained uptrend.

This is a critical point that most market participants overlook. Just because a stock has hit a bottom doesn’t mean it’s going to go much higher. Buying low isn’t a great strategy if there isn’t a significant high to sell in a reasonably short period of time.

I highly recommend using the “middle entry” strategy, but I would modify it in two ways. First, use short-term volatility to trade the position. If you catch a bounce, reduce the position and look for a rebuy when conditions improve. Second, look to build the core position on strength, not weakness. Don’t buy endlessly until the price drops. Make stocks prove they have relative strength before you trust them.

Position averaging is standard bear market advice, but it must be done correctly to be effective.

Receive an email notification every time I write an article for real money. Click “+Follow” next to my byline on this article.

Source link

Leave a Reply

Your email address will not be published. Required fields are marked *