I’ve read before that you should never begin an article with a question, as it offers the reader a chance to say “no” and not read the article. But 1) I am not a journalist, and 2) this is a very relevant question for all of us.
In fact, it’s a question I ask myself every day as stocks fall further. Certainly the risk/reward is much better when shorting at the start of the move. But does that mean we shouldn’t short lower down? Should we be buying? Well, volatility often increases as shares fall further. This is all to do with human psychology.
When shares begin to fall, investors go through various phases.
The phases are as follows:
The “buy the dip” phase
The “this is starting to worry me and I’m not going to add yet” phase
The “wow, this is really tanking” phase, where investors begin to throw in the towel
The “I can’t take it anymore” phase, which is the capitulation stage
The first stage has historically proven a good strategy over the long term. Quality stocks are often correlated (over the long term) with rising share prices.
However, this builds a conditioning not only that every dip must be bought, but that every dip will also go up (similar to Pavlov’s dog). And whilst they usually do – we have seen share prices over the last ten trading sessions crater. It also increases complacency, which comes as a big shock when share prices fall.
Increased volatility makes investors nervous. Everyone loves volatility to the upside, but nothing is more stomach-churning than seeing large positions haemorrhage points. I had this experience myself in 2017, where I lost huge amounts because I had no exit plan. Unlike you, who are likely to be the owner of quality shares, I was the owner of absolute garbage.
Next comes the beginning of capitulation, where more and more sell, and prices fall further and further. Very often, stock prices overshoot both to the upside and to the downside.
This is because buyers are buyers because they think the stock is going to go up. And when it goes up – this is confirmation of their opinion. Therefore, they must be right, and so they buy more and others buy more too. This is why we get stocks like Versarien that trade at a market cap of £300…
