Trade the Bull… Prepare for the Bear

Dr_Reid-nameBull markets last 4-5 times longer than bear markets, so over time, self-directed investors get conditioned to think and act in ways that are counterproductive once the music stops. Because recognizing the start of a bear market is difficult, even for professionals, it behooves the prudent investor to mentally prepare for a change in trend. I call this “bi-directional thinking.”bear vs bull

This is not the same as being a perma-bear during a bull market and constantly missing out on the rallies because one imagines that the market has reached a top.

Bull markets climb a ‘wall of worry,’ which means that they almost always appear overdone. The psychology required to trade a bull market successfully requires the ability to not be overly influenced by sharp, sudden downdrafts, like we had in January.

In other words, effective bull market psychology requires overcoming the Recency Effect, which is the natural human tendency to ascribe excessive importance to what just happened. That said, the uni-directional activity during a bull market can subtly attenuate our perception of risk. Let’s look at 6 ways this can happen.

Chasing Leaders: Bull markets evolve in phases and leadership rotates. For example, Chinese shares might be shooting higher while the U.S. indices are flat (last half of 2007); energy shares might be smokin’ hot while the rest of the market is lackluster or down (first half of 2008); biotech might be threatening to crash while chips are popping (mid-March, 2016).

up and down marketDramatic price movement catches everyone’s eye and the chasing game is fun to play… until the music stops. Chasers are conditioned to expect the continuation of strong up-moves, but that’s the perfect trap during bear markets, which have some of the strongest rallies imaginable.

Swinging for the Fences: Fast markets make fast money and the access to leverage (margin) fuels the fantasy that one’s financial dreams might come true almost overnight. A cousin of chasing, for most trader/investors over-leveraged positions are the fastest path not to riches, but to a margin call. Moreover, unless you are a pro, it’s virtually impossible to think and behave rationally with a large position on.Options trading

Buying high… sell higher: Bull markets, whether in stocks or tulips, rely to some degree on the principle of the greater fool. Buying high and selling higher works quite well when a rising tide lifts all boats. This habit, however, is extremely dangerous in bear markets, when every rally is faded (sold). Then, fools who buy high are punished for it.

Shooting at anything that moves: In bull markets one need not be particularly accurate in one’s fundamental or technical analysis to make money. And in fact, as Nassim Taleb suggests in Fooled by Randomness, positive performance might be solely the result of dumb luck. The kicker, as Taleb also points out, is the psychological tendency for investors to take credit for successes and find excuses for losses. This subtle form of self-deception will get one in real trouble if one happens to be on the wrong side of a trend change.

Holding Strong Opinions: Bull markets rely on opinionated thinking as a form of entertainment in the financial media. Those with contrarian arguments generate a lively debate, boost ratings and offer the occasional valuable insight. Skeptical gurus who continually call for a top in a bull market eventually become irrelevant, but not necessarily dangerous. Usually the worst that can happen if you follow them is that you miss out. That’s not fun, but it’s not a disaster.

bullishIn bear markets, however, strongly held opinions can do severe damage to an account if the opinions are wrong. This sort of ‘thinking’ can lead to averaging down or trying to simply ignore the underwater position.

Averaging down makes things much worse and trying to ignore a large paper loss is difficult for most people because it is staring you in the face on each monthly brokerage statement. The temptation to trade harder to recover the capital loss might be difficult to resist, which usually just digs a deeper hole.

Draw-downs, paper or live, are difficult to tolerate, so many investors eventually reach their ‘Uncle Point’ and liquidate. This predictable phenomenon actually creates the final bottom.

Holding Losers: Additionally, holding strong opinions usually leads to holding losers. This is probably the most pernicious and dangerous habit one can develop from trading in an extended uni-directional environment.bear marker

In bull markets, short-term drops in a stock (or index) due to bad news, such as a missed quarterly earnings target, are opportunities for hedge funds and institutional investors to add to their positions. That’s because statistical studies indicate that long-term fund performance depends mostly on the average entry price: the lower the better.

This puts a floor under the market 2-3 standard deviations below the mean during the bull trend.

Bull markets, therefore, condition individual investors to either buy the dip or ignore the paper loss if one has been caught buying too high. However, behavioral finance research indicates that taking small profits and postponing large losses is a common (and unfortunate) human tendency. In a bull market, this tendency is rewarded… in a bear market it is punished.

Bottom-line: Trade the bull, but mentally prepare for a different type of market. Think bi-directionally. Clean up your investing psychology so you are not your own worst enemy when the bear strikes.

Until Next time,

Kenneth Reid

Dr. Kenneth Reid holds a Ph.D. in Clinical Psychology. He is currently a trading coach and has published articles for Forbes, SmartMoney, and SFO Magazine. He has also appeared on CNBC and writes a column on The Trading Psychology for Trader Planet. Kenneth Specialized in trading stock and futures and is working on a futures trading book.