Why can’t more investors buy low and sell high?

Stocks are the only asset that the average person wants more of when prices are high than when they are low. Why do people treat stocks differently than buying a car or a pair of pants at the mall? A possible explanation resides within a combination of factors: mental error on the part of the investor and fear. Recently extrapolated results (good or bad) carry an expectation that they will continue infinitum. When stock prices decline, the macro or fundamental conditions at the time are likely to be cloudy and, sometimes, downright scary. The average investor expects the trend to continue and is afraid to lose more money. Instead of pulling the trigger to buy more stock at the lower price for the longer term, the result is often an emotional decision to sell, which is the exact opposite of the desired response. If the rationale for the original purchase was shaky to begin with, the situation may be further exacerbated.

When stock prices are rising and valuations are high, the opposite happens. Investors incorrectly believe that the sky is the limit and buy more based on the fear of missing out on potential profits. It is understandable that professionals are afraid to underperform the indices and competitors, which could lead to losing clients. However, investment professionals make the same emotional decisions as individual investors, but they have more pressure riding on each one of those decisions. Few advisors and institutional investors will sell at a market top, in part because tops are difficult to call. In fact, it’s easier to go along with the crowd mentality to explain away poor performance, especially if everyone gets caught in the same bear market, rather than miss out on riding the wave for that last 5-10 percent rally.

It begs the question as to what can be done to avoid these issues. First, if you are making forecasts, be aware of recency bias, which can cause you to erroneously put too much weight on the most recent news and trends, as well as overlook long-term risks and trends. Be careful when forecasting, as all trends end and reverse—hockey stick projections rarely come to fruition. Study market tops and bottoms, and those of individual stocks you know well. Identify whether or not the news was positive or negative. Understand what analysts’ future expectations were at the time, as well as the actual outcome.

Additionally, change your focus and that of your clients. Every investor has unique needs. Some have the time frame and risk tolerance to be fully invested in the equity markets, but most don’t. The best path to take is to focus on meeting financial goals within defined risk tolerances rather than beating an arbitrary index that is likely well outside of your client’s risk tolerance. Continual client communication around this focus is paramount so you can avoid dreaded conversations about why the S&P was up 12 percent and they were only up 7 percent. The further away you get from the last bear market, the more this will need to be reinforced.

Why do investors follow the herd?

In general, most investors and people follow the herd. We are social animals who are dependent on others for survival. We learn through our parents, families, friends, communities and society at large. Most people don’t like to be different; they want to fit in. Many are unable to embrace their individuality and, in many cases, care too much about what others think and, as such, are conditioned to conform to family or societal norms.

From personal experience, it is difficult taking a contrarian stance, particularly when the expectation is for the market to decline. The two most common responses to this are amusement and pity. How you react depends on the confidence in your research and how much you care (or don’t) about what other people think. Ego can easily get in the way and chide you into believing you are wrong when the “experts” think something different. Standing outside the herd can often lead to second guessing yourself and being second guessed by clients.

For many, it may be easier to accept someone else’s view than to do the homework to formulate a unique point of view, particularly if there is a lack of confidence in their ability. It constantly amazes me how easily and quickly people will accept and spread information without ever checking its validity or taking time to think about it in a rational way. Just look to social media or reality shows as prime examples.

How does one effectively stand outside the herd? To start, don’t listen to the so-called experts in the news and media. While news and media outlets host very smart and successful guests, the objective is not necessarily to help your business and your clients to be profitable. Often the focus is on short-term trends and concepts, or to make money for themselves and their clients.

Don’t listen to the “experts” at the bulge-bracket investment banks either. Brokerage firms and the analysts who represent them get paid based on trading volume. They sell optimism and short-term trading ideas, which are essentially emotional judgements and suppositions that can cloud rational investment decisions. When it comes to investing, optimism and hope are not sound investment principles. Analysts are useful in helping us to understand what the consensus view is and to gather interesting information and details. The reality is that the number of mainstream market pundits who have actually been successful in predicting market tops and bottoms is close to nil.

Focus on long-term trends and resist the need to be invested at all times. If the goal is to outperform the markets over the long term, there will be times when you need to go against crowd mentality. The media constantly pounds at us that if you are not fully invested all the time, you could easily miss out on the best days, which provide all of the year’s returns, once again, playing on the fear of missing out. Conversely, what is not mentioned is missing out on the worst days. The higher the market valuation, the lower expectations should be for long-term returns. Regardless of what the market does in the short term and how many of the best days you miss, there are times when the long-term risk/reward does not warrant being invested in the market.

Why do investors make decisions that are not
congruent with their investment time horizon?

Many investors with a long-term investment time horizon unfortunately make ridiculously short-sighted investment decisions. Some of the reasons have already been touched upon: fear, hope and recency bias. I’d like to introduce a few additional insights. Advances in technology have given us many wonderful tools and have leveled the playing field for individual investors. That being said, those advances lend themselves to ‘ticker-itis’, which is a constant streaming of quotes or information that not only leads to indecision and excessive trading, but also distracts from focusing on value-added tasks and long-term goals. Make a conscious decision to avoid constantly checking market information; instead, set a calendar alert for a specific time to check the market. In this way, you remain informed and not sidetracked by the overwhelming stream of data

It’s human nature to have an emotional tie to money. Mike Tyson once said, “Everybody has a plan until they get punched in the face.” Taking a hit on a stock that blows up or riding down a broad market decline often feels a lot like a punch in the gut from Iron Mike himself. It can suck the air right out of you. The fear of losing more money kicks in and you sell in a panic. The long-term, rational, well-thought-out financial plan is down for the count because the fear instinct kicked into high gear.

Greed also has its cost. As an example, a stock on the broader market surpasses all expectations and the only thing driving it higher today is the fact that it was up yesterday. However, when the rationale for investing in the stock no longer exists, it is time to make an exit. Most people don’t behave this way. The brain receives a huge shot of rewarding dopamine that feeds on itself wanting more so the greed stops the sell and the stock eventually has a downturn.

Hope can be just as damaging as fear or greed. It embodies the wish to return to the same value you started out with after a stock turns down—the expectation of hockey stick fundamentals in stock prices or positioning your investments for such an occurrence because this is what you want to happen. There is a disconnect when what you are hoping for is not a likely outcome and the associated risk is too high, or not appropriate. Being bullish just because you want to make money is not the best strategy. As is often the case, the reality is the investor doesn’t realize they’re behaving in this way. The question becomes, how does one stay on the long-term investing path? You must take the Zen approach and truly know yourself. Of key importance is maintaining a trade journal that details the reasons behind each of your investment decisions. Recording each transaction can often deter impulsive actions. Keep your long-term goals handy for reference. If the transaction doesn’t meet the long-term goal criteria, take your finger off the button. Remember, too, that pride goes before the fall. Be mindful not to let ego get the better of you. It is very easy to become overconfident, which may lead to careless error or risky behavior. If an error is made, accept it, learn from it and move on. Evaluate all investment opportunities on their own merit with respect to how they may help you and/or your clients. Assess the portfolio as if yesterday’s closing price is your purchase price and ask the following questions:

• Based on yesterday’s closing price, would you still choose to own the portfolio?
• Are you holding on to the portfolio so that you can get back to even?

Identify and document your strategy and process. As a financial advisor, it’s paramount to know when and why you buy or sell. My general rule of thumb is that if any stock or investment is down more than 10 percent relative to its sector or peer group, it gets reassessed. Be objective in your interpretation of new information and check your hypotheses consistently, as there is a propensity to view new data as a confirmation of prior beliefs. Whatever the parameters are, adhering to your well-thought-out disciplined process will go a long way toward minimizing knee-jerk activity.

In closing, focus on what you can control and let the rest go. Acknowledge that the market will do what the market will do. Rely on your circle of competence, research and especially your decision-making process to propel you forward. In doing so, you may effectively resist the herd mentality, elevating you and your practice to better serve the individual needs of your clients.

See referenced disclosure(s) (1) (2) at https://blog-dev.americanportfolios.com/disclosures/ .