Rebound trades: The risks of revenge trading and doubling down

This February, in the spirit of Valentine’s Day, we could discuss rebound relationships. But instead we discuss something just as dramatic for investors: rebound trades.

Whether it’s JLo and Ben Affleck or the latest escapades of the Kardashians, rebound relationships can be full of drama. Rebound trades can be just as dramatic. We highlight two key examples of rebound trades: revenge trading after a loss and doubling down after a gain.

An investor buys a growth stock with strong prospects and analyst ratings. Unfortunately, the growth only continues until the next earnings report, when expenses come in much higher than expected and the stock falls by 20% in a matter of days. The company seems to be improving, but then the CFO is suddenly terminated and the reason becomes glaringly clear: earnings for the last few years have to be restated. The stock drops another 40% overnight. The investor is unsettled, since they had strong conviction in the company and invested a substantial sum.

Annoyance quickly gives way to action. I’m not just going to sit here and accept these losses, the investor says. I’m going to make it all back, and then some. Although the investor normally holds relatively stable companies that pay dividends, they can’t find any strong candidates in this group. The investor hears about a small-cap mining stock that an influencer on social media says could double in just a few months. The investor doesn’t normally hold small-caps or miners, but the influencer sounds well-informed and a double would put the portfolio back in profit. After doing some research to confirm the influencer’s bullish view, the investor invests heavily in the miner. As luck would have it, a foreign government in the miner’s largest territory announces that it will nationalize all mines with immediate effect. The news sends the stock into freefall. A bad loss on a stock has now become a significant loss for the investor’s portfolio.

This example of losing and then losing some more is perhaps familiar to many investors, even if the details are different in each case. What is less familiar — but perhaps even more dangerous — is the next example of doubling down after a gain.

It’s 1998 and a dividend investor has finally decided they can no longer just sit there and watch everyone else make money from tech stocks. It’s time to get a piece of the action. They invest a moderate amount, only to see an immoderate gain by the end of the year. Pleased with this success, they invest the same amount the following year — no need to get carried away —, only to see an even bigger gain. As the millennium comes to an end, with some economists already talking about the risk of a crash, the investor sells their tech stocks and moves the proceeds into Treasury bills. The return was far more than they had hoped for, so no need to take any more risk. 

But then, what would happen if they could get just another year like the last two? The investor can start to picture early retirement and a cottage by the lake. They invest all the gains from the last few years, plus more of the portfolio that would normally be in bonds, to benefit from further growth. Unfortunately, the market doesn’t cooperate with the investor’s plans. People have realized that few of the high-flying tech stocks are making money; valuations suddenly seem awfully high. The market falls 80% by year-end. The investor has lost a big part of their portfolio, which is now back to where it was at the start of the decade.

Rebound trades can be dangerous for investors.

Revenge trading: Instead of reflecting on the loss and building a strong investment plan, the investor is motivated to take action for a quick gain. This can easily backfire, especially if the investor selects stocks they have not carefully considered in terms of their investment knowledge, time horizon and risk tolerance. In some cases, the second loss can be even larger than the first.

Doubling down: In our example, the investor had been very successful and exited their investment but couldn’t resist coming back for more. While this risk can affect all investors, it can be particularly hard on those who were previously skeptics, get swept up in the excitement of unusual gains and suddenly lose their normal sense of caution.