On the Law of Averages

By Kenneth Robson on October 23, 2012 • ( 0 )

It is an expression still occasionally used after a run of gambling losses, to justify one’s persistence. “On the law of averages I’m likely to win next time.” My bad luck must surely change soon. Losing streaks don’t last fore-ever. Eventually they do come to an end, but perhaps not before our loss becomes horrendous.

We may find ourselves using this argument after a succession of losses on the stock-market.We may think that if we keep doing what we have been doing, sooner or later we will have a big win and win back what we have lost. Tossing a coin is a truly random event; sooner or later you can be certain that wins and losses will even out playing two-up.

Stock prices may move unpredictably in either direction, but will frequently continue on in the same direction almost indefinitely. Similarly they may remain static for prolonged periods. A row of losses demands a re-think of our strategy. Are we constantly repeating the same mistake? Are we trying to trade against the momentum of an established trend?

There is another consideration. Stocks tend to move in unison. A common expression for this is “the tide lifts all boats”. Mind you with the stock-market the movement is rarely uniform across the board. Knowing this can greatly increase the likelihood of trading success. The single most important question to ask of ourselves prior to investing is this. Is it a bull, or a bear market?

The answer may not always be self evident, especially at the outset of the transition. A few points that may assist in reaching a conclusion:

In what direction is the overall price movement of an appropriate index such as the ASX 200 heading? Up, down or sideways?
Is the price action of the index and the security to be traded above or below a 200 period moving average?
Is the price movement making new highs or lower lows? The first sign of a bull market is failure to make new lows.
What is the market response to bullish and bearish market news. In a bull market, bearish news fails to evoke a fall in price. On the other hand, bullish news in a bear market tends to be ignored.

Making a correct call on the state of the market will greatly improve your chances of a successful trade.