People who follow the market too closely have a bias towards action. They become bored and restless and want to do something even when the conditions are not favorable. This tilt leads to the most common advice in a bear market: build positions by averaging them.
In theory, this is a great idea. No one can time the market very accurately, so a good way to build a position is to make smaller purchases over a longer period of time and hopefully arrive at a pretty good average entry price.
There is no doubt about the wisdom of entering positions gradually, especially in a poor market, but executing this strategy can be difficult. The most common mistake is to average a position too long and fast. When positions are too large in a poor 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 time the exact lows, and the combination of the two tendencies is that they act too early.
Better to buy later than early
In previous columns, I have discussed my view that it is better to buy later than early. If you buy after a low has been made, there are precise support levels and the upside is more likely to be sustained. When you buy in the teeth of a dip, you have to hope that the downward momentum is going to stop and reverse. When the market is oversold, there can be some good countertrend bounces, but it is extremely difficult to predict future market lows.
Averaging positions in a bear market probably does more damage to accounts than anything else. The big risk is that the timing is wrong and the position becomes uncomfortably large and refuses to bounce. This evokes strong emotions and triggers panic reactions.
It is also important to recognize that there is a risk of betting on the wrong stocks. Not every stock that plunges into a bear market will recover when conditions improve. If you keep adding as it falls lower, you are setting yourself up for a big loss. This is another reason why it is important to look for some strength before adding a position.
I’m a big fan of a step-by-step approach to trading and investing, but too many people get it wrong. They are very focused on buying weakness and trying to time the bottom. You must be willing to add strength, not just weakness. People tend to want to buy weakness because there is the illusion that they are taking a chance, but with investing, you make the big money not by buying the lows but by buying a sustained uptrend.
This is a critical point that most market participants overlook. Just because a stock hits a low doesn’t mean it’s going to go much higher. Buying low is not a great strategy if there is no significant high to sell in a relatively short period of time.
I highly recommend using the “entry average” strategy, but I would modify it in two ways. First, use short-term volatility to trade the position. If you catch a bounce then reduce the position and look to rebuy as conditions improve. Second, look to build the core position on strength rather than weakness. Don’t just buy endlessly as the price drops. Make the stock prove it has some relative strength before you trust it.
Averaging in a position is typical bear market advice, but it must be done correctly to be effective.
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