Two things you should never do when investing
In trading there are only two things that will eventually kill your account for sure. One is mean reversion and the other is averaging down.
Now, what does this mean? Let us take a look at mean reversion first. What are we doing when trading a mean reversion system? In a world of high volatility and uncertainty about next day events, it is essential to find opportunitys. Some Traders found it helpful to trade
a system that statistically finds stocks that ran up or down further than their corresponding markets. For example, if the NASDAQ goes up or down by an average of 2% every single day, but you are trading a NASDAQ Component Stock that goes up or down by 4% every day you found a stock that moves better than the corresponding market. This is usually covered by the beta of that stock. Obviously this stock is more risky than one that would move the same amount as the underlying market itself.
Traders have refined these findings and came up with a solution that tracks the performance of the stock itself and scans breakouts. If our stock goes up or down 4% on an average every single day and we find it suddenly moving by 6% it might be a good idea to trade it. But we will not trade it in the direction of the move, instead we trade it against the move. That is the idea behind a mean reversion system. You trade a stock that has run up more than it historically could back to the other side and hope it goes down again to its usual value - thus mean reversion.
Usually this works well and you can make a lot of money with such a system until the day it stops working. And on that day you will probably lose the better part of your account. Several Hedge Fund Managers did find out on their own when they went broke using such a system. The problem ist, that you will trade the same routine over and over again, going against a market that moves further than it statistically could. So naturally you will do the same on the day it doesn´t work anymore but the biggest problem is that you don´t know that it will not work any longer. In going against the market you build up on losing positions which are not easy to close especially because you are in them mentally. So when the market goes further up, you will lose on that position. If this system is the only one you trade you will lose most of your account on this occasion.
If you do it long enough - you will lose your account!!
The second thing you should avoid by all means is averaging down.
Basically you are accumulating a stock that goes down in value. It goes down further, you buy more, it goes down more you again buy it. The idea is that eventually it will turn around and you make some money because your position is big now and it only needs to go up a few points for you to be in the green.
This tends to work for a long time but in the end you will lose your account because you keep on buying losing positions and the day comes where the stock will turn around - just the second after the broker closed down your account because you could not meet his margin call.
So applying proper risk management procedures forbids to trade using either one of the above systems. Do not trade mean reversion systems and do not trade averaging down systems.