Since Wednesday was PI day (3.14), I thought I might update my PI trade article, says Dave Landry, f...
Buy High, Sell Low: How to Go Broke by Following the Crowd
03/28/2017 3:00 pm EST
Buy high, sell low, repeat until broke. Why is following the crowd a dangerous strategy for stock market investors? Steven Pomeranz, a fee-only Certified Financial Planner, explains why timing the market is so difficult.
One of the most reliable ways to lose your shirt in the stock market is to buy high, sell low, rinse and repeat. After multiple washings: “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 by buying stocks after they have risen or selling at a loss after they 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?
There is a theory called the Efficient Market Theory which claims that markets gather all available information about every company in the stock market and “price-in” this collective knowledge. This theory creates the misperception that if a stock price is high, it accurately reflects the company’s true worth, which, in turn, leads to the conclusion that it’s impossible to profit from buying a mispriced stock. Therefore, any attempt to beat the market is rendered futile.
However, 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. Choosing your stock picks with the “efficient market” in mind will have you riding those stocks’ coattails and stuck in the “follow the crowd” approach. We know for a fact that most people will end up as market casualties using this “follow the crowd” investment philosophy, and we also know that, 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—very expensive—thinking.
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. So, as these popular stocks continue to rise, it becomes increasingly difficult to sit on the sidelines; and it’s this “fear of missing out” which makes most investors act irrationally.
Some say the fear of missing out is “a more enduring motivator than the fear of losing your life savings.” As hard as that is to believe, emotions can really mess up your thinking. Even professional investors who have access to deeper financial insight and can quantify risk are subject to the trifecta of greed, fear, and peer pressure. If these investors struggle, how can the individual investor hope to succeed?
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. When you get that feeling that an investment theme is “gonna be great,” it’s vital that you have the skills to evaluate it correctly. 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 practice patience through buy and hold investing. Instead of continually buying and selling based on hunches or taking short-term gains and avoiding short-term losses, do nothing. As I always say, “doing nothing” (unless you’re a teenager) is an active decision.
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. Especially during times of market peaks, market troughs, and market turbulence, the urge to “do something” becomes overpowering for many investors.
But “doing nothing” requires pausing to reconsider those impulses to buy or sell and then declining to act on them. This is not as easy as it sounds since fear and greed are hardwired into all of us. Discipline is needed to ignore these emotions.
Finally, 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 for you to recite when things get really frothy and exciting—or scary and depressing.
To find out more, go to www.onthemoneyradio.org
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