Why share price bounces matter more than you think

Anyone who watches the financial news regularly cannot fail to miss the fact that headlines focus on bad news more often than good. That is because, as Lord Beaverbrook once put it, “pessimism sells.” For investors, specifically, “loss aversion” is a big mental bias – studies show that when we see stocks fall, we panic more than we celebrate when they rise by the same amount. However, this is a pity. 

Tim Bennett Head of Education at Killik & Co outlines his top reasons why investors should focus on the positives. 

Missing a trick

The truth is that stocks often bounce quickly and aggressively following a drop, but this fact often passes unremarked upon by the media. As a result, investors may be panicked into dumping stocks, only to miss out on the substantial gains that follows. These rises happen for three main reasons:

• Sentiment
• Technical forces
• “Short covering”

What follows is a quick summary of each.

Sentiment

It has been well documented that crowds behave in irrational ways sometimes. When it comes to investing, overexuberance, as stocks climb, can turn to mass panic when they fall. In short, greed can become fear in a matter of hours sometimes, as the stock market showed at the start of the COVID pandemic. The point? The reverse is often also true when sentiment recovers, but people pay less attention to it. Once short-term traders think a stock has hit a trough, they often pile in and more than reverse the decline – you miss this fact at your peril.

Technical forces

Short-term investors, in particular, use systems and signals to help them decide when to buy and sell stocks. Moving averages are tracked and when a stock hits a historic “resistance” or “support” point, it will often change direction quite suddenly. Again, miss out on a stock bounce, triggered by a buying spree off a support point, and you may forego some decent gains.

“Short covering”

Hedge funds are a good example of what are called “short sellers.” These are investors who try to profit from price falls. They do so by borrowing stock, selling it, and then waiting to buy it back and return it. In the meantime, they hope the price will fall. If it doesn’t, they face a scramble to buy back the stock they need to return to the original lender. This can cause a “short squeeze” and result in a sharp price pop.

The implication for investors

Imagine for a moment that all three of these forces combine just after a stock has dropped – the scope for a fast rise is considerable. The trouble is, as studies from JP Morgan amongst others have shown, if you miss even a small number of these “best” investing days, because you are trying to avoid the damage from a drop, your long-term returns can suffer to the point where they can be halved over a decade.

The simple message is clear – don’t try to time the market and be wary of paying to much attention to negative market news.