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

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People who keep a close eye on the market have a preference for action. They become bored and restless and want to do something even when the conditions are not favorable. This tendency leads to the most common advice in a bear market: build positions by taking an average.

In theory, this is a great idea. No one can time the market with great precision, 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’s no question that it makes sense to enter positions incrementally, especially in a bad market, but executing this strategy can be challenging. The most common mistake is to average in too large and too fast a position. When positions are too large in a bad market, there is an increased risk of panic selling.

The problem is that market participants have a very strong tendency to take premature action. They want to trade, and they also want to try and time the exact lows, and the combination of the two tendencies is that they trade too early.

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Buying later instead of early is better

In previous columns I have discussed my opinion that buying later rather than early is better. If you buy after a low, there are precise levels of support and there is a greater chance of continued upward momentum. When going against 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 counter trends, but it is extremely difficult to predict market lows prospectively.

Averaging positions in a bear market is probably causing more 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.

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It is also essential to recognize that there is a risk that you may be betting on the wrong stocks. Not every stock that falls in a bear market will bounce back when conditions improve. If you keep adding as it gets lower, you’re putting yourself at a big loss. This is another reason why it’s important to look for some strength before adding anything to a position.

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

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This is a critical point that most market participants overlook. Just because a stock has bottomed out doesn’t mean it will rise much. Buying low is not a good strategy if there is no significant high to sell in a reasonably short period of time.

I highly recommend using the ‘average in’ strategy, but I would change it in two ways. First, use short-term volatility to trade the position. If you catch a bounce, lower the position and try to buy again when conditions improve. Second, try to build the core position on strength rather than weakness. Don’t just buy endlessly when the price drops. Let the stock prove it has some relative strength before you trust it.

Averaging into a position is standard bear market advice, but it has to be done right to be effective.

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