With the stock market in another big swoon, I thought it would pay to review one classic method of making money in stocks. Hopefully, this post will help us fight the emotion of fear which grips all investors during major corrections, of which we’ve had tons in the last year or so.

It’s no secret that stocks are falling once again. Personally, this month is starting off terrible for my portfolio. After having one of my best months in two years last month, when most hedge funds posted steep losses, nearly all of my gains for the year are once again slowly disappearing. So of course, I’m becoming gripped with fear about continued losses and, worst off all, going into negative territory for the year, which has not happened to me in over five years.

However, since these types of extreme corrections have become quite common in the last year so, during the current bear market, I’ve gotten somewhat used to these big swings and the fear that accompanies them.

During these sell-offs, it’s important to remember that to make money in any type of investment game, and especially the stock market, you need to Buy the Bad News.

It’s extremely difficult, and counter-emotional, to buy stocks on major declines and bad news. At that point, you’re losing money, and afraid of future losses. But, buying on declines and bad news is the only way to make money and, in fact, it’s the only rational way to act.

Simply put, from a rational perspective, as stocks decline the risk/reward ratio improves. As stocks rise, the risk/reward ratio deteriorates. That is basic common sense. So, obviously, you need to buy on the declines and the bad news. In addition, when people sell on bad news, the price of the stock begins to reflect the bad news, and as such further downside becomes limited.

In other words, stocks discount future news, so during huge declines and bad news, one’s mind should try to focus on potential positive changes that could reverse the decline, as opposed to negative events that can accelerate the decline. Conversely, when stocks are moving up (i.e. you are up 20%+ on a particular position) and good news is reported, one needs to immediately shift one’s focus to potential negative changes that can stem the rise and cause a sell off.

With that said, I’m off to buy some shares on the open today, with the expectation of selling at a profit later this month, when market sanity returns and the current huge fear of a financial meltdown has once again dissipated.

The trick of course to buying on declines is to:
1. Make sure you do your research and are buying companies that are cheap financially, and could recover on good news in the months ahead.
2. Buy Slowly, as you never know how long the correction will last.
3. Stay Diversified. Some stocks will never recover from the correction, but many will. By staying diversified, you’re guaranteed to make at least some money on the eventual rebound.
4. Make Sure You Sell Into Rallies so you have cash to buy on the declines.