Buy High, Sell Low, Repeat until Broke
One of the most reliable ways to lose your shirt in the stock market is to buy high, sell low, rinse and repeat. After a while: Presto! No more shirt! Of course, no one puts their hard-earned cash into the market intending to follow this formula for disaster, but a disturbingly large number of people do it anyway. Why is this money-shredding pattern so common? How is it that timing market trends is so difficult? The simple truth is that markets and investors are susceptible to the twin engines of greed and fear that drive short-term crowd psychology and thus stock prices. Trying to play catch up to rising stock prices or cutting losses after their decline are recipes for poor results. Buying a ticket right at the beginning of a long ride up or stepping off just before it plummets back to earth requires superhuman foresight—or, more likely, very lucky and unrepeatable timing.
Efficient Markets or Crowds Animated by Greed and Fear?
Efficient market theory claims that markets gather all available information about every company in the stock market—including their future earnings—and then “price in” this information in close to real time. Stock prices are said to reflect this collective knowledge, the unseen hand of the “efficient market.” The efficient market is supposed to reduce the number of “mispriced” stocks which would present long (buy) or short (sell) opportunities. But one person’s “efficient market” is another person’s “crowd,” and crowds are notoriously fickle, ruled by greed and fear, and prone to a dangerous, over-reactive herd mentality. Aligning stock picks with a supposedly efficient market by trying to spot stocks that have recently risen and then riding those stocks’ coattails is another way of expressing a “follow the crowd” approach. We know from countless market casualties, large and small, that following the crowd as an investment philosophy is a dubious proposition. In fact, while it sometimes works in the short run, in the long run, it’s a terrific way to go broke. Impulsiveness, lack of discipline, and financial illiteracy all conspire to make following the crowd an exercise in wishful and usually very expensive thinking.
Forever Playing Catch Up
Many investors think they are being smart by not trying to second-guess experts or the recent direction of the market—most often during a bull run. But the reality is that they are still greedily chasing after price gains that have already happened and literally passing them by. Playing catch up in this way is very often disappointing. In many cases, it becomes clear in hindsight that a large portion of a stock’s gains comes shortly after its last bottom, meaning that later investors reap less upside. If you’re late to the game, you stand to gain less than early birds, and you’re taking on more risk. Greed’s rewards are watered down. Some pursue “momentum” stocks—stocks of companies that have shown strong growth in recent months or years. The problem is that no one knows for sure if that momentum will continue with further price gains in the short term or how large those might be. If anything, the market is usually ahead of itself, factoring in expectations of future earnings gains. What this means is that the current price already reflects what the stock will be worth at some point in the future—if everything goes well and nothing surprising happens (good luck with that). Again, chances are that you’ve probably missed the price appreciation driven by expectations of future profits. Not only is your upside limited, but if those expectations of earnings growth don’t come to fruition, you will be left holding the bag. The timing could go either way in these scenarios. For this reason, any honest market veteran will tell you that timing is a fool’s errand.
Fear and Capitulation
On the fear side of the equation, the positive direction or sentiment of the market may stall out or reverse at any time, making a mess out of your dreams of enjoying a long run-up in prices. If you don’t have a plan for that reversal and it does arrive, you are likely to lose your nerve, sell your stocks, and get burned. Investors who panic and sell after a stock has fallen say 15 or 20% will lock in their losses and forfeit on the chance of a rebound.
The problem for the majority of us is that we can’t predict when a stock’s or a market’s popularity is about to have the rug pulled out from under it, precipitating a mad rush for the exits. Under bear market conditions, the herd suddenly stampedes into sell mode, and investors are sorely tested to stay or get out of the market. Some people luck out and sell just a few percentage points below the top; the vast majority do not. As often as not, initial patience is rewarded with more pain, and this can continue until a floor in the price is finally set. In the financial world, people talk about bulls and bears reaching the point of “capitulation” or surrender, where the pain of holding onto their position becomes too great and they finally sell their stakes and take their losses. This is one of the worse ways to invest, as it means you’ve sold near the point of maximum pain/loss. For even the most sophisticated investors, exact or even “close enough” (less than 10% loss) timing is all but impossible
Crowds, Popularity, and Underlying Value
This isn’t to say that the crowd is always wrong. Stocks that are popular with the crowd often enjoy long bull market runs, creating a kind of halo effect that makes them seem special. However, just because a popular technology company is trading at $200 per share does not make it worth $200 per share. Popularity is not the same thing as underlying value. It’s difficult to sit on the sidelines while markets are rising. The “fear of missing out” gets worse over time and has been called “a more enduring motivator than the fear of losing one’s life savings.” Absent any objective way to analyze the value of a company and compare that to its stock price, this sort of greed becomes even more dangerous. And even professional investors that have access to deeper financial insight and can quantify risk are still subject to peer pressure, greed, and fear—so much the worse for individual investors.
Antidotes to Fear and Greed
The good news is that there are antidotes to the fear and greed syndrome. One is having a system for evaluating companies and their stock prices. It is good to be worried about your own excitement over a new investment “opportunity.” Instead, there are a number of books you can read and study to gain the skills needed to analyze a company’s finances. Talking things over with a financial planner or another expert can also help. An additional antidote to fear and greed is to extend your investment timeline and practice buy and hold investing. Instead of continually buying and selling based on hunches about momentum or taking short-term gains and avoiding short-term losses, do nothing. It is all but guaranteed that if you own stocks you will be tempted by greed and fear to buy and sell them as the market moves up and down.
During times of market peaks, troughs, and turbulence the urge to “do something” (to capitalize on gains or minimize losses) becomes overpowering for many investors. But doing nothing—holding onto your investment positions—is actually an active decision and a difficult one to boot. It requires pausing to reconsider impulses to buy or sell and then declining to act on them. This is not as easy as it sounds. Fear and greed are hardwired into all of us, and discipline is needed to not act on these emotions, at least, not in the way that the rest of the crowd does. Remembering Warren Buffett’s famous advice to “be fearful when others are greedy and be greedy only when others are fearful” is a helpful prayer to recite when stocks seem too frothy or too beaten down.
Finally, diversification of your wealth is extremely important and will protect you from the possibility of certain investments losing value which will undoubtedly happen at some time. Diversification works against the temptations of fear and greed by reminding you that it’s crucial to build and stick with an investment foundation that can withstand the vicissitudes of the market. Smart portfolio diversification reinforces a commitment to the choices you made when setting it up, dovetailing with the buy and hold/value strategy.