Beware Picking Bottoms
The market is up around 17% in the last three months and to many investors the better performing stocks now look to expensive to buy. These investors who are too scared to buy a stock in an uptrend (stocks with rising prices) instead want to buy stocks that have fallen, hoping to ‘pick the bottom’.
Most investors find it hard to resist buying a stock after it has suffered a large fall. This is natural, because we ground our concept of “value” according to price.
If we see a stock fall from $10 to $5, we, at some level, still view it as a $10 stock. Thus, the temptation is to buy a stock that has recently fallen, because some part of us believes (or hopes) that it will naturally gravitate back to its previous level.
To traders considering trying to pick the bottom, I would strongly caution against fighting the market by buying stocks on their way down.
It’s the pyschology, stupid
Psychology is the crux of trading of the markets. Not only does psychology rule the way markets operate, but your personal psychology will rule the way you trade.
Greed and fear are the two biggest emotions behind traders’ behaviour and therefore are major influences on the market.
The legendary trading psychologist, Brett Steenbarger, says that fear begets fear. For this reason, he says, bear markets are shorter than bull markets, and falls in share prices are likely to be quicker and sharper than the earlier gains. This explains the common market cliché “up by the stairs, down by the elevator” – prices will generally creep higher but will usually slump at a faster pace.
Fear in market, fear for yourself
The market, made up entirely of humans, reflects all the emotions of the humans. For this reason, Steenbarger says, the market doesn’t instantly swing from pessimism to optimism. Just like most humans, the market’s mood improves gradually, not instantly. Rather, the signs of improvement in the market’s attitude toward a stock can be identified by savvy traders.
Now I am no Behavioural Science expert, but I do utilise technical analysis – which is a trader’s best friend in interpreting the market’s mood.
In technical analysis, these gradual mood changes can often be identified by various signs of divergence. For example, new lows might be made on falling volume, or the price might fall as the relative strength indicator improves. In both cases, the market is showing you that the full-on bearishness of the past is starting to ease.
Fear of bottom picking
So, what does this have to do with bottom picking? Fear, both your own and the market’s, is closely tied to the way we treat stocks when they fall lower.
The fear of missing out on an ‘easy’ trade might cause you to take a position in a falling stock too early. So, how do you avoid pulling the trigger too early? Look closely at the market’s behaviour: is technical divergence indicating the selling is easing?
Bottom picking is usually an unpleasant habit. But if you can watch the market, and identify when bearishness is in decline, you can be prepared to take a position when the price starts moving in the right direction. The technical signs of divergence should tell you to get ready, but the price action should tell you when to go. Once again, patience, and control of your emotions, is key to successful trading.
Head of Education
Australian Stock Report
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