One of the biggest mistakes made by novice traders is that they feel that in order to be successful, you need to be able to accurately identify the tops and bottoms of the market. The more experienced traders know of course that this is rubbish. Put simply, in order to be successful you need to generate more profit from winning trades and a smaller loss from losing trades, such that the net result yields a return that is above the market average. Let me explain in more detail.
The first point to make is that tops and bottoms are defined by time frame. So although the market has continued to lose ground since October of last year, there have nonetheless been plenty of “bottoms” along the way.
click chart for more detail
At the time, many people were thinking that these points represented the “real” bottom of the market, and we did see a significant turn-around after these dates. However, with the benefit of hindsight, we can see that they were all false bottoms. Many traders found themselves in the unfortunate position of watching a profitable position sour, and ended up taking a loss. The experienced trader would not have made this mistake.
The other point to make is that you don’t have to pick the exact start and end of each trend to be profitable. As long as you get reasonable movement in the desired direction you can make money. If you missed the successive bottoms in the above example by a few days, you would still have been able to take advantage of plenty of upside.
Another fact you need to be aware of is that when attempting to pick bottoms, you will inevitably get it wrong some of the time. That is simply a fact of life and there is no point in throwing your arms up in defeat every time a trade goes against you. The goal is to let your profit run and to cut your losses short.
From a longer term investment viewpoint you could argue that regardless of how far away a sustained recovery in the market is, we are very likely to be close to the bottom. The market could fall another 10-15% (anything is possible) and it could take another 2 years before prices start to really recover. But that doesn’t mean that you can’t still take advantage of the already significant pull back and enter into an investment at an attractive price.
Take for example CBA shares, which as I write this article are trading at $40.52. Now it’s certainly reasonable to expect that they could extend the massive losses which have so far resulted from the credit crisis, but it’s difficult to imagine that they won’t ever recover from the current economic difficulties. In 5 years time, you won’t care that you picked them up at $40.52 instead of, say, $36. If historical growth rates and past recessions are any indication, it’s entirely reasonable to expect that they could be trading at $80 in 2013, and have paid you many dividends along the way. The great thing about longer term investing is that a few dollars here or there really don’t make a big difference over the long term.
What is certain about bottoms is that you can only identify them in hindsight. By the time you can clearly argue that the bottom has come and gone, it will often be too late to take the maximum advantage. So forget about what might happen, and instead focus on what is happening now. Are the conditions right to take a trade? Does the stock represent good value? If so, go for it, manage your position, and forget about always chasing the perfect trade.
Make the markets work for you,