In major downtrends and bear markets, market players tend to suffer their biggest losses in a similar way. They find a stock that they are convinced will do well in the longer term and then continue to buy it as it trends lower. Rather than cut losses quickly, they convince themselves that the market is wrong and that the stock is even a better buy at a lower price. The stock keeps falling and when it fails to produce a meaningful bounce, there is great anxiety because they have too much capital tied up in the stock and they then sell out of fear, disgust, and dismay.
I've seen the scenario play out multiple times over the years and it is the sort of trade that causes the biggest losses for investors. It is very hard to see this when it is happening to us as emotional distress pushes us to dig a deeper hole.
This problem manifests itself in other more subtle ways as well. The primary reason this occurs is that there is a tendency to become emotionally connected to stocks that we follow for a long time, and there is also a false sense of security that the stocks we know well will not treat us badly.
The best way to deal with this problem is to embrace the idea of repositioning. As I've often discussed, one of the best things that any trader or investor can do is to overcome inertia. When we are losing money we have two choices: we can sit there and hope things improve or we can take some sort of action. Patience will work well over the long term if you are holding the right stocks but, more often than not, taking some sort of action will improve your odds of success even if it may feel like what you are doing is very poorly timed.
As we've seen several times in the past couple of weeks, there tends to be big bounces in bad markets. Far too often these bounces are opportunities that are squandered by investors who just sit there and hope that the worst is over. The stocks that they wished they dumped a week ago now hold great appeal for the long term once again.
The biggest mistake that has taken place in the last couple of weeks is a rush to build long term positions too early. The timing has been quite poor as the selloff continued and now there are some large unrealized losses in those holdings. Since we bought for the 'long term' we tend to ignore the opportunities we might have to improve our cost basis by making some short term moves.
I've been using Disney (DIS) as an example of a way to build a long term position in the current market. I have made a couple of buys and was lucky to time a pretty good entry on Thursday morning. I still want to build Disney for the long term but since I have a big gain I reduced it into the counter-trend bounce and will now look to buy it several more times as it develops. It doesn't much matter if I have a loss or gain at this point. All that I know is that there is a big bounce and the odds are high that I can probably buy it again at a lower price. If I can't, I can still buy it in the future at a higher price.
Another way to reposition and deal with inertia is to sell a stock when it may feel like a very bad time but immediately buy a different stock so that also seems to be a great bargain. This prevents the problem of being too large in one stock and also helps to guard against emotional reaction. I have several stocks that I want to build longer-term. If one is acting poorly, I can dump it much easier if I feel if there is an alternative that offers similar potential.
The main benefit of these moves is that I have reduced my risk, breaking the inertia and am no longer in the position to fall into the trap I outlined above about averaging into a stock and then selling in despair.
Repositioning is often more helpful psychologically than financially because it creates a sense of control. We tend to make bad decisions when we feel we can't control the situation. We make much better decisions when we don't feel like victims.