7 Common Trading Mistakes Part 5: Buying stocks on short-term dips

7 Common Trading Mistakes Part 5: Buying stocks on short-term dips

A common tax mistake is caused by anchoring. Anchoring is the idea that when a stock trades in a range such as $20-$25 per share for a few months, investors begin to think that $20-$25 is a reasonable future price for the stock. Therefore, lots of people cannot resist buying the stock on a dip to $15 under the theory that the stock is likely worth $20-$25. But this ignores the idea that new information is constantly arriving into the market. A stock that dips $5 to $10 is likely to have fallen because of bad news regarding the firm or its industry. In a perfectly efficient market there would be no reason to think that this stock is more likely to rise than other stocks.

But the market is not perfectly efficient. The problem with this trading strategy is that evidence tends to indicate that buying a stock on a short-term dip is exactly the wrong thing to do!

Evidence shows that short term dips (weeks or months) generally tend to be followed by further declines. This is called trending or momentum. Historically markets have transferred wealth from those who trade based on “anchoring” to those who base their decisions on the evidence that market prices have tended to trend in the short-term. Specifically, stocks have tended to trend (i.e., exhibit momentum) over time intervals such as 3-9 months in recent decades. When short-term trading (i.e, months) is involved, it appears that the “trend is your friend”. Investors should not make the mistake of buying stocks on short-term dips.

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