Share Market Basics: Investing Mistakes to Avoid in a Down Market

You found a company with an amazing product. Strong demand was fuelling big earnings and sales growth. Mutual fund sponsorship was top-notch, and the stock was in a bullish technical pattern. But the stock went lower soon after you bought it because you were wrong about the direction of the general market.

Mistakes are plentiful during a market downtrend. Avoid these common ones, and you will be able to keep your hard-earned cash intact.

Buying before a base completes

During the recent market correction, many stocks pulled down to their respective 200-DMA and only some found support. To some traders, long-term support was a buying opportunity. The key to making money in the market is waiting until a base completes before buying. In most cases, stocks that come down to their 200-day lines do so amid signs of institutional selling. Wait the stock to prove itself more, and look for signs of institutional buying as the stock builds the right side of the base. Then you have a legitimate base.

Buying every possible breakout

Bullish stock charts tempt investors all the time during down markets. Some growth names will hang in there with compelling charts. A breakout may work for a while, but it will likely be short-lived. While stocks that hold up the best during down markets can go on to be the next leaders, they still should not be bought during a downtrend.

Keep holding a stock or even averaging down

A stock trades at Rs 100 a share. Your cost basis is Rs 100. The stock heads lower, and you buy an equal amount of shares at Rs 80, lowering your cost basis to Rs 90. Then you add further at Rs 75 after it breaches its 50-and 200-DMA. The problem is that you’re averaging down in a former leader that’s under tremendous institutional selling pressure. You will be doing some serious damage to your portfolio. It rarely makes sense to buy a stock that has the potential to spiral lower before finally hitting a bottom.

Buying low P/E stocks

Price-to-earnings ratio is a common valuation tool. But buying/selling decision based on P/E is not a prudent move. Expensive stocks can become cheap, but cheap stocks become cheaper in a down market. Trying to catch a stock "on sale" is fraught with risk. In many cases, stocks with low P/E ratios are suffering from weak fundamentals, where shrinking market share results in lower earnings growth. That’s not something you want to see in a stock. Remember, some of the best merchandise in the stock market often sells at a pricey valuation due to strong fundamentals and bullish growth prospects.

Stop paying attention

It is easy to lose interest when stocks are selling off, but market downtrends let high-quality names take a breather and eventually build new bases. When a new uptrend is confirmed, breakouts deliver the biggest gains. During a market pullback, try hard to make a list of stocks that held up the best. A few will show limited signs of distribution (heavy-volume selling) on the way down and accumulation (high-volume buying) on the way up. Focus on the most resilient names with the least amount of technical damage. They will generally be your best prospects.

Read our last week article on "Still the No. 1 Rule for Stock Market Investors: Always Cut Your Losses Short"

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Disclaimer: Information contained herein is not and should not be construed as an offer, solicitation, or recommendation to buy or sell securities. It is for educational purposes only.

MarketSmith India is an investment advisory product based on William O’Neil’s Can Slim method with model portfolio, pattern recognition, idea lists powered by institutional quality data